The Stock Volatility Signal Flashing for the 3rd Time Ever

We're seeing extreme levels of tranquility for stocks right now

Senior Quantitative Analyst
Aug 9, 2017 at 6:55 AM
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In May, we discussed the historical volatility (HV) of the S&P 500 Index (SPX) falling below 10% for six straight months. It has only decreased since then, to its lowest level in almost 50 years. The 20-day HV for the index has fallen below 4% for the first time since 1969, and has been in the single-digits for 170 days in a row for just the third time ever. The only other two other times this occurred were in 1963 and 1964 (S&P 500 data goes as far back as 1928).

In short, we’re seeing extreme levels of tranquility for stocks right now. This week, we will take a look at what the HV reading means for stocks going forward. 

Building A Bracket

Going back to 1928, I organized the trading days into five equal brackets based on the HV of the S&P 500. As I mentioned earlier, the current HV for the index is about 4%, placing it comfortably in the first bracket of lowest HVs. Next, I summarized the index returns going forward for each of these brackets.

SPX HV Bracket

SPX Three-Month Returns

Below are the three-month returns for the S&P 500, depending on the level of the 20-day historical volatility for the index. As you can see, the average return when HVs are lowest is 1.74%. This is smaller than the average return of 1.85% across all brackets, but the return is positive over two-thirds of the time, which beats every other bracket.

The best average return comes from the highest HV bracket. When HV tops 19.1% (the lower end of the high HV bracket), the S&P 500 averages a 2.07% return over the next three months. However, this high average return comes at the cost of higher volatility. When the market goes down over the next three months, the loss on average is 11%.

SPX HV 3 Month

SPX Six-Month Returns

This next table looks at an extended time frame of six-month returns. In our current bracket of low historical volatility, the average six-month return is 3.45%. Again, this is smaller than the average overall return of 3.69%. The percent positive is about 70%, which is good, but not quite as good as that second bracket. That highest HV  bracket has a relatively low average return and the lowest percent positive.

SPX HV 6 Month

SPX One-Year Returns

The last table summarizes the returns for these brackets over one year. This table indicates that low historical volatility seems good for the market. Over this time frame, the average one-year return is 7.57%, with 68% of the readings positive. The average return and percent positive for the two lowest HV brackets beat these numbers. Thus, the longer-term SPX returns show market underperformance when the HV is the highest. This is a good sign for traders, as long as the market calmness continues.

SPX HV One Year

 

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