How Stock Price Volatility Broke All the Rules

Like outbreaks of the plague, add to the list of things that supposedly don’t happen anymore: the market’s recent extreme volatility.

Equity market volatility went over the top in the beginning of February, as the Standard & Poor’s 500 tumbled into correction territory, dropping 10%. Volatility, a measurement of how much stock prices jump around, ballooned far more than the market’s slide customarily would warrant.

Then at mid-month, starting Monday Feb. 12, stocks nudged up again and volatility subsided. Still, just because volatility has abated for now doesn’t mean that it can’t come again. And soon.

Early February’s seeming overreaction in volatility means that stock prices were jittering around manically, as gauged by the Cboe Volatility Index, or VIX, which measures futures contracts. Why? Most likely because the market has been unusually quiet since mid-2016, when it began a slow and orderly ascent. Prices moved in narrow ranges in daily trading sessions, around 0.5%. Then, when the market went south, it freaked out traders who weren’t used to such a sudden dive.

“There had been a lot of complacency” among investors, said Jeff Schultze, investment strategist at ClearBridge Investments.

The usual relationship between volatility and the market, Schultze noted in an interview, is that for every percentage point drop in stock prices, the VIX climbs 4 points. So, on Thursday Feb. 8, the S&P dipped almost 4%, and volatility climbed to 33.4 from 27.3, or 22%. By the usual rule of thumb, volatility should have only risen 16%.

During the last two corrections, in 2015 and early 2016, the VIX peaked at 31 and spent most of the time around 26. The historical average for this metric is 19.

But during the long rally that began in mid-2016, volatility typically was in the low- to mid-single digits. Then came February’s shock to the system. It was as if the market was lazing around in the hammock for more than 18 months, and suddenly found itself in the middle of a battlefield, scrambling for survival.

What changed? Interest rates are clearly on the way up. And in Jerome Powell, the new chairman of the Federal Reserve, which sets the benchmark for short-term rates, there may be less sympathy for slowing the pace if some economic indicators flash red. Under Janet Yellen, his predecessor, the Fed backed away from planned hikes in 2015 and 2016, when troubling economic news surfaced, limiting increases to just one for each year.

In fact, the most widely accepted explanation for the market’s tanking is a fear of rates moving up faster than anticipated. An encouraging jobs report apparently touched off the selling wave. Low rates have been longstanding catalysts for stocks, which looked much more appealing when bonds and other fixed-income instruments weren’t paying much. Besides, low rates made borrowing for stock purchases cheaper.

All along in the rally’s later stages, there was an uneasy sensation that the good times were too good to last. Right before the slump, in late January, Korn Ferry surveyed the Fortune 500’s investor relations–and 55% said the market was overheated and due a correction.

Not helping either the market or volatility were structured products that made highly leveraged bets against higher volatility. When they imploded, they had to sell stocks to cover their positions, which contributed to the mini-panic. “Sell they did,” wrote Yale Bock, head of YH&C Investments, in a note to clients. “Over and over we’ve seen these leveraged entities cause market sell-offs.”

What’s next? At mid-month, when the market bobbed back up into positive territory, many were relieved to see volatility returned to its average level, 19.3. That could be a head fake, though.

“Volatility is still likely to be elevated in the short-term,” said Michael Arone, chief investment strategist at State Street Global Advisors, in an interview. Uncertainty about inflation and the Powell Fed’s rate-hike schedule will keep investors on edge, he said, and susceptible to “violent reactions.”

To RSM’s chief economist, Joe Brusuelas, “It’s premature to claim volatility has ended.” His firm did a proprietary survey of companies over the past six months, he said in an interview, and that showed many of them preparing to raise prices.

 We’ve all just seen this movie. The plot goes: Inflation fears lead to interest rate increases, which leads to stock market turbulence – and higher volatility.