If you had asked that question at the end of February this year, you could have plausibly pointed to two key factors to explain the drop in volatility. First, the U.S. equity market (as measured by the S&P 500) had rallied 10% since November’s surprise election of Donald Trump – and rallies in equities typically are accompanied by drops in volatility. Second, the post-election euphoria was characterized by a drop in correlation (the degree to which stock prices move in tandem): As some stocks and sectors rallied a lot more than others (e.g., financial stocks rose more than 20% between the election and the end of February while energy stocks went up only 2%), overall index volatility was curbed.
But the story has changed a bit since the end of February. The price rally now appears on hold, with the S&P 500 virtually unchanged, and realized correlation, instead of dropping, has actually ballooned from 0.10 to 0.30. Those two key factors damping volatility through February don’t seem to be factors anymore, and yet the collapse in equity volatility persists. In fact, U.S. equity volatility, as measured by the simple average of volatility of the top 100 current stocks in the S&P 500, is at multi-decade lows (see chart).
Even more perplexing is how the drop in stock volatility coincides with increasing uncertainty about Washington’s policy agenda. Healthcare reform hit a roadblock and a tax code overhaul seems far away, as does a boost in infrastructure spending. On the monetary side, while the Federal Reserve is tightening rates at a measured pace for now, its leadership is up in the air – Chair Janet Yellen’s term expires early next year.
And if today’s quiet stock behavior is based on investors’ confidence that companies will meet upcoming earnings targets, we would note that quarterly bottom-up estimated adjusted earnings-per-share (EPS) growth of 9% for the S&P 500 as of 31 March 2017 is the highest since the fourth quarter of 2011 (source: FactSet). In other words, the bar is relatively high for companies, in aggregate.
Much uncertainty, yet little volatility
So U.S. stock volatility is cratering amid a high degree of uncertainty regarding the policy outlook. How can this be? The most likely explanation is that investors have taken a wait-and-see approach to substantive changes in fiscal policy. That’s a defensible posture, for now. U.S. equity valuations are elevated but the probability of significant changes to fiscal policy is not zero, leaving stocks treading water. The result is low volatility and muted volume.
But we don’t expect this low-volatility regime to continue indefinitely (or maybe not even much longer). At some point, we could see movement toward meaningful changes to the tax code. And in the near term, companies will either meet (or even beat) relatively lofty Q1 EPS expectations, or they won’t, and the latter would be a nasty surprise for investors conditioned to positive surprises.
As active investors gather more information about the outlook for individual stocks, they will choose whether to increase or decrease their single name and sector exposures. In other words, U.S. stock volatility has collapsed, but we have reason to believe it will rise again – and perhaps by a lot.
Jason Goldberg is a portfolio manager focusing on equity derivatives and correlation strategies.