By Edward J. Perkin
For much of the past few years, volatility has been quite low – but not lately.
Prior to the final week of the second quarter of 2015, there were zero days when the S&P 500 Index rose or fell by more than 2%. In the third quarter, there were eight such days. As recently as August 17, the Chicago Board Options Exchange SPX Volatility Index (VIX), a measure of implied future volatility on U.S. stocks, was at 13, a very low level relative to its history. One week later, without warning, it hit 53 intraday, more than quadrupling in the span of five trading days. As of early October, it was in the mid-20s, well above historical levels.
What caused the spike in market volatility and the sell-off in equities? Many market commentators have pointed to fears of slowing economic growth in China and uncertainty around the timing of Fed policy. While these may be the proximate catalysts, they do not explain why stocks have reacted so violently, in our view. We believe that a confluence of factors has led to the sudden, sustained jump in volatility in recent weeks.
- Price-insensitive sellers: Much of the equity market sells stocks without regard to fundamentals, valuations or price, including index funds and ETFs, along with pension funds and variable annuities that have implemented “risk-parity” or “minimum volatility” programs requiring them to “de-risk” when measures of volatility (like the VIX) spike.
- Regulatory pressures on brokerage firms: Historically, during a sell-off, Wall Street trading desks would use their balance sheets to buy stocks, which would often stabilize the market. As a result of the so-called “Volcker Rule,” firms are prevented from making directional bets with their own money.
- Excessive crowding: In the first half of 2015, the breadth of the stock market had grown very narrow, with a handful of stocks accounting for the bulk of the market’s performance. As momentum-based investors crowded into a smaller set of stocks, they became vulnerable to bad news.
In conclusion, history has shown that the best opportunities often present themselves when uncertainty is running high. If part of the market is made up of investors who sell without regard for price, it must represent an opportunity for those willing to do the hard work of fundamental analysis and valuation. Investors with the fortitude to embrace uncertainty may be able to benefit from volatility, in our judgment.
Edward J. Perkin is chief equity investment officer at Eaton Vance
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