The Q2:2020 plunge in Volatility is Underappreciated. Is a New Low-Risk Bull Underway?
As previewed in our June 2 note (“Volatility is on the cusp of another “Buy” signal for stocks, just barely hovering above the 24% annualized figure that keeps this signal bearish”), a new signal in our models was triggered last week. Annualized volatility for the S&P 500 fell below 24% on June 2, to 20.8% according to our proprietary measure (utilizing ATR, or average-true-range). Our volatility model flashes a Long signal for U.S. stocks when this measure tracks below 24% because as we detail below, there are no low-volatility bear markets in the U.S. The bottom line: the VIX plunge is underappreciated, and believe it or not, a new low-risk bull may be underway.
In this analysis, we measure “risk” as volatility. Sure, there are other risks to stocks-valuations, leverage, the Fed, etc. but when it comes to timing and describing the U.S. equity market, volatility reigns in our book.
The U.S. equity market has three regimes when it comes to price and risk.
- Low-Risk Bull
- High-Risk Bull
- High-Risk Bear
Note the absence of a “low-risk bear market”. There are no low-risk bear markets in the U.S. – bear markets happen in spasms, marked by increasing volatility. “Stocks go up the escalator, but down the elevator” is the old operator’s maxim. Another observation: every High-Risk Bull Market eventually gives way to a High-Risk Bear. Here’s the data since 1990:
We manage portfolios, size positions, and manage risk through the lens of volatility:
1.) Low-Risk Bull
- Fewer, larger positions
- Low volatility stocks
- High gross, high net
2.) High-Risk Bull
- Max diversification
- Smaller position sizes
- Opportunistic shorts
- Low gross
3.) High-Risk Bear
- Concentrated short positions
- Diversified, smaller long positions
- Low net
Investors are wise to monitor political developments as well as Covid-related risks. The brutal bear market of the 1970’s for example began when the market peaked in January 1973, six months after the Watergate break-in, and prices didn’t recover until 1980. Nixon’s downfall coincided with the OPEC embargo and defeat in Vietnam to mark the low point for the U.S. in the Cold War.
The stock market’s treatment of that climate and importantly inflation among other factors, included the singularly brutal combination of higher share price volatility and plummeting share prices. Imagine that. Despite taking on increasing risk, investors not only are not rewarded for that risk, but are punished. Reversing the risk-reward polarities can wreak havoc in markets built on such maxims.
President Clinton’s impeachment, on the other hand, occurred during the late 1990’s i.e., the internet bubble. Clinton was impeached 12/19/98, and acquitted 2/12/99. During that time, the stock market continued what it began in 1996 – rising rapidly in price and rapidly-rising volatility. The high-risk bull market of the late 90’s was the mirror image of the 70’s and a powerful reinforcement of the “high risk/high reward” notion.
Source: FlowPoint and Bloomberg
The U.S. market may now be transitioning from a High-Risk Bear to a Low-Risk Bull. Position accordingly.