By now, you’ve probably heard that the stock market suffered its worst start to a year in history.
The S&P 500 Index (SPX) declined 6.0% in the first five trading days of the year. Going back to 1957 (year of SPX inception in its 500 company form), the next largest decline was a 5.3% rout in 2008.
Additionally, 2016 has the potential to be far more volatile than 2015. In fact, as shocking as it may be to hear this, 2015 was actually pretty tame.
The CBOE Volatility Index (VIX) did spike above 50 in August. However, the VIX measures implied volatility, which is the market’s estimation of future short-term volatility.
Basically, traders and investors panicked because they hadn’t seen a correction in several years. The sudden scramble for protection in the form of SPX put options caused a super-spike in the VIX.
Instead of implied volatility, I want to measure how large and dispersed the actual price changes were over the course of the entire year. The chart below shows annual realized volatility for the SPX since 1980:
To compute realized volatility, I’m taking the standard deviation of the daily price returns for each year.
With a standard deviation of returns of just 0.70%, it’s not a surprise that 2013 had the lowest realized volatility in the post-crisis era. After all, the Federal Reserve was conducting $85 billion of quantitative easing (QE) stimulus per month that entire year.
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QE may not benefit the real economy all that much, but it does artificially suppress volatility.
The Fed’s third round of bond buying, QE3, ended in October 2014. As you can see, 2015 was more volatile than 2012, 2013, or 2014. However, 2015’s realized SPX volatility was still below the long-term average.
Without QE in 2016, it wouldn’t surprise me at all if this year was as volatile as 2011, which had a standard deviation of returns of 1.47%.
Not only does market volatility create opportunities to profit from dislocations, but it also increases the likelihood we’ll make emotional decisions at inopportune times.
Diversification helps us dampen our portfolios from volatility – and it reduces the chance we’ll panic and sell stocks after a big stock market decline.
Investors with Treasuries in their portfolios know exactly what I mean during these early days of 2016.
Safe (and high-yield) investing,
Alan Gula, CFA