Volatility in the stock market is a measure of how much stocks move up and down. Volatility is most often caused by uncertainty and external events in the stock market. In most cases, with the exception of volatility and options traders, volatility within markets is often not good. Due to the compounding effects, higher volatility causes lower geometric average returns over time. Furthermore, in the short and long-term, volatility causes large decreases in market indices, wiping out gains. The main measure of volatility is the Chicago Board Options Exchange Volatility Index (VIX). The VIX projects implied volatility over a 30-day period by measuring changes in S&P 500 options prices.
In 2023, the market saw lower volatility than the previous years, with VIX holding between 10 and 25. Large spikes in the year's volatility were caused by regional banking stress and debt ceiling concerns. While the US Federal Reserve was back and forth, moderate inflation, high levels of consumption, and a strong labor market helped keep volatility low in 2023.
Currently, the VIX is at a recent low, down 28.85% over a 1-year period and up only 2.95% year to date. VIX has been slowly declining since pandemic highs, with a slight increase when the Russian-Ukraine war broke out.
Long Term GDP Growth [1] [2]
Economic Indicator | Annual Average | 4th Quarter | ||||||||||||
23 | 24F | 25F | 26F | 27F | 28F | 29F | 23 | 24F | 25F | 26F | 27F | 28F | 29F | |
Canada Real GDP | 1.1 | 0.9 | 1.5 | 2 | 2 | 1.9 | 1.8 | 0.9 | 1.2 | 1.8 | 2.1 | 2 | 1.8 | 1.8 |
US Real GDP | 2.5 | 2.3 | 1.8 | 1.9 | 1.8 | 1.8 | 1.8 | 3.1 | 1.6 | 2 | 1.9 | 1.8 | 1.8 | 1.8 |
Stable GDP growth rates coincide with lower GDP volatility as it decreases overall uncertainty within an economy. The current outlook for GDP in Canada and the US shows a stable outlook with healthy real growth numbers.
By looking at multiple market indices, we can further get a better and more accurate look at how market expectations of volatility are forming.
The Merrill Lynch Option Volatility Estimate (MOVE) Index measures bond market volatility. The MOVE Index measures implied volatility of bonds ranging from 2 to 30 years using the Black-Scholes model. The MOVE Index provides insights into future expectations of volatility within the market. Currently, the MOVE Index has been on a decline, posting a 1-year loss of 31.8% and a year-to-date decrease of 24.45%.
Another similar measure is the S&P 500 Dynamic VIX Futures Index. The VIX Futures Index measures the contango of short and medium-term VIX futures to act as a vehicle to gain exposure to mid-term volatility increases. Currently, the indices have posted a 9.01% 1-year loss and since the 2020 highs have shown a steady decline.
The CBOE SKEW Index provides further insight into volatility outlooks. The SKEW measures the perceived tail risk of S&P 500 returns over a 30-day horizon. One way in which the SKEW has departed from other volatility indices is the overall short-term movement. The SKEW has posted higher highs and higher lows in the short term.
To gain further insight into the movements of the SKEW, we must look at VVIX. The VVIX is the CBOE’s measure of volatility within the VIX index. Currently, the VVIX is nearing all-time lows posted in 2019 and 2014. A rising SKEW and an all-time low VVIX indicate that while volatility outlook is stable, investors are complacent but also cautionary. We can derive that from the given indicators that investors are hedging steep declines due to likely macroeconomic concerns. This indicates divergence in market expectations; most investors don’t expect massive disruptions, however, there’s a minority of players who have long tail concerns.
Currently, the COT of the S&P 500 indicates a large amount of hedging activities on the futures market by institutions. Based on the current geopolitical climate, this makes more sense; geopolitically, there are a large number of flashpoints that we have seen arise and while currently these issues remain regional, there is a risk of medium-sized problems becoming larger. For lack of a better term, there are 10 runners on 1st and they all have a lead-off.
Currently, the largest long tail risk in the market is geopolitical tensions and conflict. Looking at the current global conflicts, alarming trends are shifting. Previously, conflicts were more consolidated to individual larger conflicts, however, over the past 3 years, the nature of conflicts has changed to a larger number of small events. In previous decades, large wars were mainly restricted to individual regions such as the Middle East, Korea, or Southeast Asia. Since 2020, the number of large armed conflicts has decreased and are more characterized by small-medium sized conflicts such as what we are currently seeing in Israel, Gaza, Myanmar, Ethiopia, Yemen, Ukraine, Russia, South China Sea, and Haiti [3]. This is largely attributed to deglobalization and the regionalization of the US. As deglobalization of the US continues and other world powers grow, we can expect an overall increase in the number of global conflicts, however, a decrease in the average size of conflicts [4]. Geopolitics and trends such as these are a big driver of concern over long-tail risk.
On August 2022, the Inflation Reduction Act was signed, a piece of legislation that touched on Industrial, Climate, and Trade Policy. The act was the largest investment into green energy, however, it also greatly increased investments into the US economy to incentivize domestic manufacturing [5]. While the bill was called “The Inflation Reduction Act” it had very little to do with inflation itself and was closer to a Pro Economic Nationalism Act, which isn’t specific to just the Biden administration as the Trump administration had more tariffs than any other presidency [6]. Overall, there has been a global movement towards the nationalization of economic conditions and this also presents a long tail risk. The shift to economic nationalism risks disrupting global supply chains, leading to reduced efficiency and increased costs, causing increased market volatility. Furthermore, the environment hinders international investment and business operations, risking reduced profitability and valuations, which poses a massive risk in increased volatility [7].
Moving forward, while it is challenging to predict black swan events, we can gauge potential increases in market volatility by analyzing indicators such as corporate profits and inflation. Over time, these factors often signal shifts in economic stability and investor sentiment.
Corporate profits post-COVID have risen and remain relatively stable and show no signs of decline, which further backs lower future volatility expectations. Corporate profits would also benefit from future rate cuts. Currently, interest rate cuts expected in Canada are expected to come sooner rather than later. The US Federal Reserve recently came out saying the rate cuts will be later rather than sooner [8].
10-year expected inflation rates in the US initially declined from the late 2022 highs, however, increased with higher than expected CPI. If inflation expectations continue to rise, then this would pose a risk for increased volatility in the market.
In conclusion, the future market volatility outlook remains relatively low, however, there exist large long-tail risks due to geopolitical and macroeconomic uncertainty that institutions are taking into account. In the short term, market volatility is priced in to decrease. In the medium to long-term, geopolitical risks present themselves so does the potential of lower volatility with interest rate cuts and increased profits. Deglobalization and future escalation of conflicts present the largest risk to increased volatility within the market, however, even with a need for caution surrounding an increase in probability of a long-tail event, the market indicators and investor sentiment generally point towards a continuation of reduced volatility into the future.
Asset class performance in the face of high to low volatility
Very favorable (++), moderately favorable (+), neutral (0), moderately unfavorable (-), very unfavorable (--)
Low Volatility Environment
· U.S. Treasury Bonds: ++
· Municipal Bonds: ++
· Large-Cap Growth Stocks: ++
· Consumer Staples Stocks: ++
· Small-Cap Stocks: ++
· Real Estate Investment Trusts (REITs): +
· Healthcare Sector Stocks: +
· Infrastructure Funds: +
· Dividend Stocks: +
· Money Market Funds: 0
· Fixed Annuities: 0
High Volatility Environment
· Silver and Other Precious Metals: ++
· Volatility ETFs (e.g., those that track the VIX): ++
· Commodity ETFs (e.g., oil, agricultural products): +
· Cryptocurrencies (e.g., Bitcoin, Ethereum): +
· Global Macro Hedge Funds: +
· Small-Cap Stock: -
· Emerging Market Stocks: -
· Convertible Bonds: -
· High-Yield/Junk Bonds: --
· Technology Stocks: --
· Biotechnology Stocks: --
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