When stock-market volatility is already near record lows, valuations high, monetary policy on a tightening path and geopolitical uncertainty present, it is only logical to expect more pullbacks ahead.
After all, everything in market tends to revert to the mean.
But short-term volatility, just like shot-term returns, is very difficult if not impossible to forecast.
Higher volatility in 2017 than a year before was one of the most often-cited predictions at the end of last year, with every analysts warning of bumps in the road.
Yet, 2017 will go down in history as one of the least volatile—ever.
“Risk was the dog that didn’t bite this year,” wrote Hamish Preston, senior associate at S&P Dow Jones Indices, referring to lack of declines in U.S. equity markets.
According to Preston, average observed one-month volatility in the S&P 500 SPX, +0.90% in 2017 was lower than in any other year since 1970.
Lack of volatility stocked investor confidence, pushing the market to record levels with gains in every month of the year on a total return basis and without as much as a 3% pullback along the way. The 200-day moving average, a long-term trend line that indicates momentum has been rising every day since May 2016, according to FactSet.
Since January 1990, 47 of the lowest 56 closing VIX levels have been observed in 2017, as well as two new all-time low closing levels, according to Preston. On Friday, Vix VIX, -10.20% fell nearly 10% to 9.46.
But veteran equity analysts should have seen that coming, according to Nicholas Colas, co-founder of DataTrek, a market research firm.
Low levels of volatility on the S&P 500 can easily be explained by surprisingly higher levels of volatility in individual stocks and sectors that resulted in falling correlations among industries.
Read: Beneath a calm surface, the stock market is undergoing a major change
Correlation is the degree to which two assets move in relation to each other. Negative correlation means two assets move in opposite direction, while positive correlation means they tend to move in tandem. Zero correlation means assets move independent of each other.
Low or negative correlations between assets in a portfolio usually reduces overall volatility and enhances returns—in this case of the S&P 500, according to modern portfolio theory.
“Last November, after presidential elections, correlation between S&P 500 sectors collapsed from about 70% to 50%. The rest is pure math: more variable returns among sectors resulted in lower overall volatility and higher portfolio returns,” Colas said.
The average historical correlation between sectors on the S&P 500 is about 50%, according to Colas.
“That means that 50% of the price can be explained by fundamentals of the industry while the rest is driven by the overall market. But since the financial crisis, all sectors became highly correlated for several year—during which we had risk-on, risk-off days, when everything moved together,” Colas said.
Correlations began to decline over the past few years but it was late last year that the decline accelerated, he said.
“Republican victory in the congress and the White House gave markets hope about easing regulations and cutting taxes. Most importantly, it would remove gridlock that was present for years,” Colas said, referring to the surprise election of President Donald Trump last November.
“On the index level, markets love gridlock, but not on the sector level. Without gridlock in Washington and fiscal policies impacting businesses, there would be winners and losers, so markets repriced and correlations fell,” Colas said.
So, what’s the outlook for volatility and correlations? Just like short-term returns, it is extremely hard to nail down the level of volatility over the next year.
If correlations between individual stocks and sectors remain low and barring any unexpected shocks, overall market volatility is unlikely to rise, Colas theorizes.
“In any given year, VIX tends to peak in January and October, so we could very well see higher Vix during those months next year. I would also expect higher volatility in November if it looks like the Democratic Party is headed for the victory in mid-term congressional elections,” Colas said.