The Ebb and Flow of Market Volatility
Volatility is, by nature, a changeable beast, constantly fluctuating with market changes, macroeconomic factors, and investor sentiment. It simply wouldn’t be “volatile” if it were to remain constant. In 2023, we’ve seen a significant dip in stock market volatility, achieving levels typically associated with periods of macroeconomic tranquility and investor complacency.
Understanding the Drop in Volatility
You may wonder, what’s driving this reduction in the Volatility Index, also known as the VIX or the “fear gauge”? A multitude of factors contribute to this decline. The S&P 500 has been unusually steady, macroeconomic data, and company earnings have shown promising trends, and banking sector stresses have abated. The ascendancy of AI has also ignited hope for the future, and a general sense of positivity has permeated investor sentiment.
Interestingly, this pattern is not new or unexpected. The VIX often commences the year at higher levels, calming down by the time we hit summer. However, this predictable pattern should not breed complacency.
The Potential for an Upturn in Volatility
Even as the same seasonal trends contribute to lowering the VIX, they may soon drive it upwards. A glance at historical charts reveals that volatility frequently bottoms out in July, subsequently rising through October (even if we disregard the extraordinary year of 2008).
However, the fact that this is a common pattern doesn’t guarantee a repeat performance this year, especially since the underlying cause of this cyclicality remains a puzzle. Yet, investing is a game of piecing together disparate information to glean a slight edge.
At present, the scales seem to tip towards a surge in volatility. The seasonal trend is a given, but the continuous stream of positive surprises from economic data or company reports seems unlikely to persist. Instead, we may start experiencing the harsher economic repercussions of the recent spree of aggressive rate hikes, potentially eroding the current wave of investor optimism and complacency.
Preparing for a Change in the Wind
This shift in volatility is not a cue for panic or for anticipating a market crash. Nor is it an invitation to rush into buying a volatility ETF, given the high holding costs and the requirement for precise timing to turn a profit.
However, it is a wake-up call to consider protecting your portfolio against a potential market downturn. With low volatility, this protection can be acquired at a lower cost. It might also be wise to adopt a more cautious approach, at least for the time being. In the end, staying alert to the changing winds of market volatility can make all the difference in navigating the turbulent seas of investment.
