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Perspectives on 2017 market volatility

A wrinkle in time

Individuals 06.22.2018 2 MIN READ

 

From a market perspective, 2017 was the calm before the storm. Then, February’s tempest blew in a turbulent first quarter, with a significant spike in volatility. But if we look through the lens of history, we get a clearer picture of “normal” volatility, and see the wisdom of a diversified and rebalanced portfolio.

 

Perspective is the gift that time gives us. Especially when we look at market volatility. Let’s examine the atypically calm year 2017 and how it might have led to unrealistic expectations for the first quarter that followed:

  • Realized volatility was unusually low, in the 2%-4% range
  • Historic volatility has been higher 99% of the time
  • Realized twelve month volatility has been between 8% and 18% over 69% of the time, with 12%-14% most typical

 

Implied volatility needn’t suggest fear

Traditionally, investors and traders look at the options market to assess near term volatility as implied by options prices (the VIX Index.) This index is often referred to as the “investor fear gauge.” Since 2012, options markets have exhibited lower implied volatility, suggesting relatively calm and perhaps complacent market expectations. While spikes in the VIX Index typically accompany market selloffs, higher VIX doesn’t necessarily imply prolonged weakness. Indeed, equity markets frequently move higher despite higher VIX.

History confirms volatility. Particularly in the short term.

Asset classes like equities are prone to occasional sharp market declines. One should expect bouts of volatility, especially over short periods.

Smaller corrections are more likely over shorter periods

The chart below shows the likelihood of corrections in 5% increments over time. Historically there is a 96% probability of 5% or more corrections within any given year, averaging about 3 times per year.



Over a 12-month period the historical probability of a 5% correction from February 2018 valuation levels is 96%, and the probability of a 10% correction is 64%.

 

Steadfastness over the long haul

Drawdowns are normal during the course of any given year, yet they don’t typically last long. The danger to the investor is giving way to emotions and initiating a selloff during a drawdown, thereby missing a potential upswing in the market. Consider these takeaways:

  • 2017 was anomalous for its lack of meaningful correction
  • Intra-year declines don’t necessarily presage extended losses
  • Stocks have posted positive returns in 24 out of the past 29 years – with many of those years posting double digit intra-year declines
  • Dollar cost averaging and disciplined rebalancing can help investors convert volatility into opportunity

*Source: GS Investment Strategy Group, Bank of America/ Merrill Lynch, Crestmont Research, American Funds.

 

For disclosures relating to this article, please click here.