May 31, 2022

How Come Volatility Is So Darn Wild?

Lots of bad news is one reason. But changes in the market’s structure figure in, too.

Reported by Larry Light

“I feel the need—the need for speed!” So says Tom Cruise’s fighter pilot character, Pete “Maverick” Mitchell, in the 1986 blockbuster “Top Gun,” expressing a kinetic impulse he shows yet again in the sequel out this past Memorial Day weekend. The stock market feels that same need, and in dollar terms share trading is many times more popular than Maverick’s box office.

Volatility has accelerated faster than the new film’s F/A-18 Super Hornet. Ever since the global financial crisis, market lurches have become more common. From 2000 through 2007, there were just five volatility shocks, defined as daily increases in the CBOE Volatility Index of more than five percentage points, according to a Northern Trust Asset Management study.

From crisis year 2008 through 2021, the VIX had 65 shocks. The same volatility dynamic holds for bonds, as seen by the VIX’s fixed-income counterpart, the ICE BoAML MOVE Index, although bond prices don’t shoot around as much as stock ones.

The VIX’s long-term average is 19.5, yet the number nowadays has fluctuated between the high 20s and low 30s. As of Friday, it was 26. “Volatility is different now,” says Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management.

Key to dealing with this wild volatility is to understand its origins. The rises of passive investing, individual investors and options to short the market have stepped up the pace, the NTAM study indicates. Most of the volatility occurs when stocks are falling: Standard deviation in down markets has averaged 21.2% since 2010, compared with 11.6% in up markets, says the company’s study. The current down-market figure is way higher than that of the decade from 1990 to 2000 (14%).

For institutional investors, who are long-term players, the faster trading swirl nowadays might seem irrelevant. But several allocators say the enhanced volatility has an effect because it could lower their funded status—what their defined benefit plans need to meet obligations to beneficiaries. Further, quickened volatility complicates rebalancing, which involves trading their holdings.

More volatility lies ahead, in the view of one CIO, who didn’t want his name used: “We should expect continued volatility as the shock of higher inflation and higher rates moves into the next stage, and the market absorbs second and third quarter S&P 500 earnings, which are probably not going to live up to the expectations.”

While the woeful 2022 stock market seemed to get a reprieve last week, with the S&P 500 breaking a seven-week losing streak, few are brightly predicting an end to troubles in the equity realm. High inflation, climbing interest rates, a European war, supply chain snags and a persistent pandemic are drags on animal spirits. Among individual investors, the bull-to-bear split is 20% bullish versus 53% bearish, says the weekly American Association of Individual Investors poll.

The Spur to Higher Volatility

What brought on the jazzed volatility now? More economic and financial tumult than usual has beset the world for the past decade-plus. Higher volatility has come in waves since the financial crisis, when the VIX hit a peak of 80 in October 2008. Things quieted down for a while, until the European debt mess bubbled up in 2011 and the VIX jumped to 45. Once that subsided, the index didn’t face another big scare until March 2020, with the advent of the pandemic, when it surged to 66.

Lately, other traumas such as inflation have appeared to keep the cauldron churning. Amid the world’s many woes, says Ken Crawford, a portfolio manager at Argent Capital Management, “there’s less clarity, so we have more volatility. [Investors] are more aggressive.”

Tech stocks have suffered mightily this year, so they have proved particularly volatile, with no end in sight. For instance, Apple (volatility: 35) is much more volatile lately than the VIX (26). The iPhone maker booked decent first-quarter earnings, but the stock is off 20% in 2022, in keeping with the technology equity rout. Interestingly, Apple was pretty volatile even when it was doing well, although the level is higher now that tech is on foul odor. “Apple troughed in 2017 and has been trending higher since,” observes Michael Green, chief strategist at Simplify Asset Management.

To Nicholas Colas, co-founder of DataTrek Research, history suggests that the volatility jump that COVID-19 sparked is likely to endure for a while. “Volatility comes as a storm, and it usually takes years for it to exhaust itself,” Colas writes in a research note.

Also instructive is NTAM’s take on what hatched the greater volatility. One big factor: Indexes have boosted their share of institutions’ assets under management, to 45% last year, from 5% in 2000. The picture is much the same for individual investors. The upshot, says the firm’s Hunstad, is that fewer analysts are focusing on fundamentals. The lack of expert guidance and fewer shares traded in turn means “flows into the market have more impact than they used to,” he says. A corollary to this trend is that market elasticity has grown, meaning prices move twice as much now as they did before the financial crisis.

Alongside this change is the more important role that retail investors are playing of late. Hunstad points to the swelling inflows to exchange-traded funds. ETFs “are retail, mostly,” he adds. “And that brings in a lot of emotion” to trading, instead of professionals’ cool detachment.

In tandem with these forces is the surging popularity of volatility-oriented options such as collars, meant to act as insurance against market problems, especially with protection on the downside. The options strategies have expanded from almost nothing in 2000 to $54 billion now. Investors “have to cover when the market drops,” Hunstad says. Result: more churn.

Volatility Victors?

For professional traders, such as hedge funds, high-tempo volatility presents opportunity, as they can take advantage of bid-ask spreads and other swirling currents in the market ocean. “Anything above 30 is a good time to be in equities,” says Douglas Foreman, CIO of Kayne Anderson Rudnick.

Especially if you are a short seller. Look at the Leatherback Long/Short Alternative Yield ETF, which in its young life (it launched in late 2020) has fared very well: In buoyant 2021, it rose 22.3%, and thus far in strife-ridden 2022, 19.6%. “Our short book has done very well,” says Michael Winter, CEO of the ETF’s sponsor, Leatherback Asset Management. Notable Leatherback short positions are online used car seller Carvana, apparel peddler Lululemon Athletica, and digital sports betting company DraftKings, all of which have taken a pounding in the market this year.

In general, however, low-volatility stocks outpace the market, numerous academic studies find. A well-known study by economist Pim van Vliet, of Robeco Investment Management, finds that higher volatility drags down expected stock performance by 3.7%.

NTAM has its own method to minimize volatility risks as the standard responses don’t work—for instance, shifting from a 60-40 stock-bond mix to 40-60. “Most are unprepared to do this,” Hunstad says, as such a move involves maximum effort and trading costs.

A better idea, he suggests, is to “do a deeper dive into where risk is coming from.” His firm divides stock styles into those that compensate you for the risk of owning them, by way of dividends and relatively steady appreciation, and those that don’t. Low-volatility stocks are on the virtuous compensates-you list. Also present are high-quality names, value stocks, good dividend payers and those dedicated to environmental, social and governance goals. Ones to avoid are growth, sectors bets and cyclicals, NTAM believes. The good list performs better and with lower volatility, the firm’s research says.

In broader terms, what would it take for today’s volatility to ebb? The consensus of strategists: improved economic news. Says Giuseppe Sette, president of artificial intelligence research platform Toggle, “If inflation drops in the third or fourth quarter this year, volatility will come down like a rock.”

Meanwhile, get used to a market that makes Maverick’s flight path look stately.