Periods of Low Volatility are Eventually Followed by Volatility Expansions
The S&P 500 index (the blue line), which represents the U.S. stock market, has maintained an upward trend that started last fall.
However, the stock market has recently reached some relatively extreme quantitative measures of trend strength and volatility, likely to be a little too far, too fast.
As prices trend up, investors and traders become complacent, extrapolating the recent past into the future, expecting the trend to continue.
A directional uptrend does tend to continue; we call it momentum.
But all good things eventually come to an end. Nothing lasts forever.
One of several quantitative measures we use to determine probability is volatility, or how far and wide prices spread out.
After stock prices have been trending up for months, the market (investors and traders) become more complacent, expecting the recent past to continue, so their decisiveness that the trend will continue causes prices to tighten up.
Prices tighten up because there's less indecision or uncertainty.
Eventually those who want to buy have bought, and there's not so much "money on the sidelines" to continue to drive up prices, so the trend stalls.
Once everyone is already bullish about stocks, there's no one left to buy. We use many more quantitative indicators to signal it, but one that's glaring right now is that realized volatility has reached a relatively low level.
Below, I highlight the low trend in volatility, measured as the standard deviation of daily returns looking back one year.
This measure of historical realized volatility has declined to the low it reached at the end of 2022, just before the stock indexes declined over -25%.
But notice that by the end of 2023, a year later, the stock index retraced the -25% loss and has since trended up to an all time high.
Here we are today, at all time highs, with very low realized volatility, and the chart shows us an example that periods of low volatility (and uptrends) are eventually followed by volatility expansions (and downtrends).
A strong uptrend and volatility contraction alone don't necessarily indicate a countertrend and a broadening range of prices, but for me, it's the market, telling me overall market risk is elevated and it's time to reduce exposure to the possibility of loss, or to hedge off beta market risk.
Mike Shell is the founder, president, and chief investment officer of Shell Capital Management, LLC, and the portfolio manager of Asymmetry® Managed Portfolios. Shell Capital Management, LLC, is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies. Shell Capital provides investment advice and portfolio management to clients with separate accounts at Goldman Sachs Advisor Solutions with an investment management agreement. The observations shared on this website are for general information only and should not be construed as investment advice to buy or sell any security. This information does not suggest in any way that any graph, chart, or formula offered can solely guide an investor as to which securities to buy or sell, or when to buy or sell them. Securities reflected are not intended to represent any client holdings or recommendations made by the firm. In the event any past specific recommendations are referred to inadvertently, a list of all recommendations made by the company within at least the prior one-year period may be furnished upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities on the list. Any opinions expressed may change as subsequent conditions change. Please do not make any investment decisions based on such information, as it is not individualized advice and is subject to change without notice. Investing involves risk, including the potential loss of principal, which an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but are not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise the implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. If this website contains information regarding options trading, please read the Characteristics & Risks of Standardized Options, also known as the Options Disclosure Document (ODD). Options involve risk and are not suitable for all investors. The views and opinions expressed in Asymmetry® Observations and Asymmetric Investment Returns are those of the authors and do not necessarily reflect the position of Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.