Investors, and the media alike, have been sounding the alarm about the “unprecedented” low levels of volatility that U.S. equity markets have experienced this year. Either implicitly or explicitly, the over-arching theme is that volatility is cheap, it can’t go lower and it makes no sense…so we must be on the precipice of another 2008. After all, the last time volatility was this low was 2006/2007 and since we know what happened in 2008, watch out for 2018!
More robust inquiries into the cause of this year’s abnormally low volatility yield some observations—continued central bank intervention, low rates, stable economic growth and strong corporate earnings. All are legitimate reasons for low market volatility, and have certainly played a significant role in both subdued market risk and steady gains for equity investors over the last seven to eight years. However, these conditions existed prior to 2017, so what is making this year different? I’d argue it’s being driven by a less talked about phenomena―historically low intra-market correlations.
The above scatter plot shows the average monthly intra-market correlations of the S&P 500 sectors along with the ratio of S&P 500 Sector Volatility to the S&P 500 Volatility since January 2000. In other words, how different is underlying component volatility compared to S&P 500 Index volatility? As correlations approach one, the volatilities should converge and give a ratio of one. As correlations drop, the ratio of sector volatility to market volatility should rise; this is simply the math of how portfolio volatility is calculated. All else equal, lower correlations produce lower volatility portfolios.
The dichotomy I struggle with when trying to grasp this year’s market behavior is this: the reasons traditionally given for current low market volatility (e.g., central bank intervention, low rates, etc.) would, in my mind, be more likely to increase correlations. In fact, until recently, correlations have been relatively high―explaining why volatility didn’t plummet to historical lows until 2017. I would posit that, rather than being an indicator of a market top or some looming systemic risk that will lead to another 2008, the recent bout of low volatility is simply math. Correlations have fallen dramatically, therefore volatility has fallen.
Why does this matter? I can think of many reasons, but I’ll focus on two. First, per traditional wisdom, active equity managers have more opportunity to outperform when stocks don’t all move in the same direction. This could work out well for investors and asset managers who have stayed the course over the past few years. Secondly, should correlations increase, market volatility could rise dramatically (not even considering an increase in underlying intra-market volatility). This could lead to challenging times for many portfolios. Most of us are unable to foresee drastic changes in correlation, volatility or market direction. However, through the seemingly magical power of diversification we are able to manage portfolio volatility.
Read more in The Diversification Benefits of Managed Futures >