Nothing to See Here

By Brad Hessel - July 16, 2012 | Tickers: SPY, DOG, SH, DIA | 0 Comments

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Bouncing off the lowest quarterly reading in six years, volatility in the second quarter of 2012 (2Q12) was up 115% quarter-over-quarter, but that only brought it to slightly-above-normal levels. For 2Q12, the average daily change in the value of the S&P 500 index was ±0.76%, compared with ±0.35% in 1Q11.

We track market volatility because it is a reasonably reliable gauge of risk levels. 74% of the time from 1950 to 2012, when volatility in the S&P 500 goes up—that is, the average annual daily change in the price of the index (up or down) is greater than it was in the prior year—market performance declines. And when volatility declines year-over-year, market performance improves 57% of the time. And so far, 2012 is no exception: the S&P 500 index volatility of ±0.56% for the first six months is down 44% from the ±1.00 volatility we experienced in 2011…and market performance has materially improved from flat in 2011 to +8% so far in 2012.

Normally, the market is remarkably stable. On average, the S&P 500 index rises or declines 0.62% each day the market is open. Actually, 52% of the time, the change in the value of the index rounds to 0% (that is, the change is less than one-half of one percent). Another 38% of the time, the change rounds to 1%.

Thus, the ±0.56% level of volatility we have seen so far in 2012 is below average. If this level were to hold for the entire year, 2012 would then feature the least annual volatility since 2006 (±0.45%), which is to say, since before the 2008 crash. Here is a chart that shows annual volatility levels for the past 60 years:

After the 2008 crash, many analysts wondered if we were in for a replay of the 1930’s depression. In terms of volatility, 1929 was every bit as extreme for the DJIA as 2008 was for the S&P 500 (which itself was not created until after WWII, which is why we rely on the Dow for the 1929 data). Following the 1929 crash, volatility immediately declined sharply from the crash peak to a near-normal level in 1Q30, but then began a jig-jaggy climb that lasted through 1930 and 1931 and into 1932, peaking in 3Q32 at a level (±3.00% on average, every day the market was open!) even higher than 4Q29 had reached.

But the post-2008 pattern has been starkly—and hearteningly—different. Here is chart that compares market volatility for the two crashes:

While the extreme volatility of 4Q08 (±3.27% up or down every day the market was open!) topped anything from the Depression, in three-plus years since then, we have not come close to replicating those heights. And more importantly, the post-crash market performance has been like day (this time) compared to night (post-1929):

Of course, the +8% for 2012 is just for the first half of the year; a lot could change. Just last year, the S&P 500 index was up 5% at the half-way point but declined in the last six months of the year to close flat overall for 2011. Indeed, volatility is not predictive. That is, frenetic trading does not generate a black swan event; it’s the other way round. Clearly the combination of increased longer-term risk in the USA-highlighted by continuing budget and deficit issues and seeming political deadlock exacerbated by 2012 being an election year-and potential danger of sovereign debt default in Europe with the concomitant systemic risk of large bank failures, and the potential for a hard landing in China, plus macro-political tensions (e.g., Iran, North Korea) all continue to be challenges.

The relatively quiescent first half of 2012 may yet prove merely to be the calm before the storm. But so far, inasmuch as the market reflects the combined wisdom of us investors, clearly our consensus is that we have dodged the Depression bullet, and despite the lurking dangers and risks, we are still expecting rabbits to be pulled out of hats and the cavalry to arrive in the nick of time to save the day. Stay tuned for further updates.

And in the meantime, if you want to hedge your bets as to how things will play out, you can effectively add the S&P 500 index to your portfolio with the SPDRs (NYSEMKT: SPY) exchange-traded fund, or short it with the ProShares Short S&P500 (NYSEMKT: SH). The DJIA is tracked by the Diamonds Trust (NYSEMKT: DIA) ETF, or can be shorted with the ProShares Short Dow30 (NYSEMKT: DOG) ETF.

Previous volatility-related articles:

• This Volatility is Off the Charts (1Q09) (24 Apr 09)
• Not Your Father’s Market Volatility (2Q09) (5 Jul 09)
• Performance and Volatility: an Inverse Relationship (3Q09) (14 Oct 09)
• So Far, It’s Not Like the 1930s (4Q09) (12 Feb 10)
• Market to investors: “Be cool, man…everything’s copacetic!” (1Q10) (7 Apr 10)
• Market Volatility Heats Up in 2Q10…But Should It Be Cause for Concern? (2Q10) (26 Jul 10)
• Market Volatility Resumes Post-Crash Decline (3Q10) (22 Oct 10)
• For Market Volatility, No News Is Good News (4Q10) (12 Jan 11)
• Judging by Market Volatility, All is Well (1Q11) (11 Apr 11)
• Another Boring Quarter of Below-Average Volatility…or Was It? (2Q11) (11 Jul 11)
• Just When You Thought It Was Safe to Go Back in the Water: An Update on Market Volatility (3Q11) (13 Oct 11)
• Nerve Racking: Q4 2011 Volatility Declines, But Only To Still-Elevated Levels (4Q11) (23 Jan 12)
• Calm Before the Storm? Volatility Plunges to Utter Quiescence in 1Q12 (25 Apr 12)

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