The Return of Volatility

3 October 2014
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3 October 2014, Comments 0

Market volatility has been at rock-bottom levels for most of the year. Volatility measures the amount of price movement for a given security or underlying. It is usually expressed as the standard deviation of expected returns. Regardless of the time frame you use, this metric has been at historical lows most of 2014. For the last year, there have been several theories about why volatility has dried up. One guess is the lack of trading volume, as many investors have largely stayed out of equities since the global financial crisis. Another reason might be the artificially low interest rate environment that the Fed has created. Volatility is used to calculate a ratio that measures the risk adjusted return of assets. The current trading environment has made this measure go to extreme levels. For example, an investor has received nearly 3 units of return for every one unit of risk. Even the most risk managed strategies struggle to get a one-to-one ratio. It is likely that today’s low volatility, high return scenario will attract new money from those sidelined ¬†after the 2008 and 2009 market fiasco. It is estimated that investors have pulled out more than $250 billion from equity mutual funds, according to the Investment Company Institute. Sadly, their frustration might culminate in a mad rush into stocks, only to end in a painful correction after all the retail money on the sidelines decides to get in. Does that really happen? Absolutely, this scenario is commonly referred to as a “Minsky moment”. It is used to describe investor behavior in a persistently low volatility environment which leads investors to jump headfirst into equities – just in time to suffer a painful correction. A combination of margin debt and overall optimistic speculation ultimately leads to a significant market correction, in which the effects are felt the most by those who invest at the top. Yes, retail investors will sit there on the sidelines watching the prices go up, get frustrated with all the returns that they have missed, and finally decide to buy. As soon as they buy or pretty close to it, the institutional investors will use that time to sell their holdings to the retail investors who are new to the market. This results in the retail investor buying at the market high, while the institutional investor is selling at the market high and capturing all their profits. Once the market tops and starts to roll over, the retail investor get very fearful, and will sell regardless of price. When their frustration hits new highs, the market tends to hit new lows, they liquidate their holdings, and the institutional investors are there to buy at the new low prices. What does all this mean? It means that we should be ready for a rock ‘n roller coaster of a ride! As we go into 2015 and 2016, we expect to see an increase in the level of fear.

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