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:
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.
Asset classes like equities are prone to occasional sharp market declines. One should expect bouts of volatility, especially over short 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%.
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:
*Source: GS Investment Strategy Group, Bank of America/ Merrill Lynch, Crestmont Research, American Funds.
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