As everyone on earth is probably aware, volatility has been surging lately.
realised market volatility numbers are in the stratosphere, or at least it seems that way.
To see how high volatility has been compared to history, I looked for periods when realised volatility of the Dow Jones Industrial Average has been as high, or even higher than the level it closed at on Thursday.
I chose realised volatility instead of implied volatility, because implied volatility has a limited history.
For instance, although I consider the VIX a very important indicator of future volatility expectations, it is not that valuable in severe market Crashes.
That’s because, fortunately, we haven’t had that many (1987, 2000-2002 and 2008-2009).
We just haven’t had enough extreme declines during VIX’s life to have a statistically significant data set from which to work.
Using realised volatility instead of VIX allows us to do testing going back over 100 years.
What I found was a mixed picture. When actual market volatility (as measured by the one-month standard deviation of log returns of the daily closing DJIA values) gets this high, more often than not the market makes a low or a short-term market bottom.
The problem is, when you get extremely high volatility, sometimes the resulting market behaviour can be very alarming.
Let’s look at some charts of DJIA (orange line) to visually analyse the period from from 1901 to present day.
Periods where volatility was greater than or equal to Thursday’s closing volatility level are marked by yellow vertical bars.
The chart below, which dates from 1901 to 1919 shows where high volatility successfully coincided with a major market low in late-1903, late-1908 and right after the inception of World War I in 1915.
There were also period of high volatility in 1901, early-1907, and 1917. The problem with those instances is the market did not rebound (although it did stabilise for several months after each signal).
The next chart dates from 1929 to 1946. The thing that should be obvious is that during the entire Great Depression drop from late-1929 through the first half of 1932, and the subsequent rebound from late-1932 through 1933, volatility was persistently higher than it is right now. The same thing happened on a smaller scale in 1938, 1939 and 1940. During this time frame, extremely high volatility was not a sign that the market would rebound or that volatility would subside. When volatility got high, it got even higher. When the market fell a lot, it fell even further.
The chart below which dates from 1961 to 1989 shows the typical pattern of high volatility coinciding with a market bottom held — right after the Crash. The other thing to notice is how volatility spikes were non-existent even during the 1973-74 bear market.
During the period from 1997 to 2011, the pattern of extremely high volatility coinciding with market bottoms held. In August 1998 during the Russian debt default (there’s that word debt again), right after the 9/11 attack, and during the Enron hearings in 2002 all had high volatility readings that coincided with significant stock market bottoms. The very notable exception was in 2008, where volatility rose significantly, but the stock market continued lower.
The conclusion to this historical analysis is that when volatility reaches the level we’re seeing now, more often than not, a market low is in place. Unfortunately, when the market does not turn around, the drop can be catastrophic, as in 1929-1932 and in 2008.
In other words, high volatility usually coincides with a market bottom, except when it doesn’t, and then the decline is REALLY BAD!
As far as which version we’re likely to experience during this turbulent time, the way I’m going to play it is to sell some volatility in here. But when I do, I’m going to use the following risk strategy: my allocation is going to be even lower than the already low level it was going into 2011, and my stops are going to be wider than normal.