Vexed by Volatility

January 22 marked the 14th day in a row in which the S&P 500 recorded intra-day volatility exceeding 1%. Indeed, one of the hottest topics today is the implication behind the rise in volatility and whether it forecasts an imminent decline in excess of 5%. In my opinion, volatility is at best a coincident indicator, rising as investors become increasingly concerned of a meaningful sell-off. However, a peak in volatility has been a very dependable indication that “the end is near” – the end of the decline that is. Yet an initial rise in volatility has been less accurate in predicting that “the big one” is right around the corner. Conversely, I found that the absence of volatility is a better predictor of an approaching pullback.

Since 1960, the S&P 500 fell by 1% or more in a single day an average 26 times per year, yet surprisingly rose an average 28 times per year. During the past two years, the average simmered down to only a total of 38 days per year. So should you believe in “reversion to the mean,” be prepared for an increase in daily volatility just to get back to the average during the past 65 years. Beyond reversion to the mean, an increase in volatility is also likely in 2015 as the number of 1% intra-day moves traditionally picks up as the bull market ages.

While an increase in volatility might not be a good indicator of the start of a meaningful decline, I found that a peak in volatility was a fairly reliable indicator that the worst will soon be over. Indeed, excluding the bear market of 2007-09, whenever the rolling 21-day volatility average peaked more than one standard deviation above the mean, the decline ended an average of only six days later.

Just as an abnormally low tide signals an approaching tsunami, I find that extremely low volatility indicates that the market is vulnerable to a meaningful decline. Since 12/31/09, whenever the rolling 21-day count of days in which the S&P 500 experienced 1% moves fell to 3 or fewer, the 500 eventually slipped into a decline by 5%. Should this rule work again, and there’s no guarantee it will, the decline we are currently undergoing will morph into a decline in excess of 5% before the S&P 500 gets back to its 12/29/14 high.

So there you have it. A pick-up in the frequency of seismic activity may help scientists, but not investors, possibly reconfirming that market timing is still more an art than a science. However, if the recent past is any indication of the future, extremely low volatility is a better predictor of future market declines than an increase in volatility, for if it feels too good to be true, it probably is. What’s more, extreme spikes in intra-day volatility are more likely to signal that investors should get prepared to buy rather than bail.

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