Stock Market Volatility: The New Normal

Art by Lily Padula

“It’s quiet, too quiet.” That classic line, originally from an old Western movie, sums up what the stock market has been through lately—tranquility followed by cacophonous danger.

The stock market has shifted from 2017’s languid trading pace, where stocks climbed majestically upward and prices seldom moved more than 1% daily, and if they did, it was to the upside. Nowadays, equities are much more volatile.

And that’s a condition likely to persist owing to rising interest rates, the trend toward index fund investing, and the exodus of the massive baby boomer generation from the workforce.

The change from calm to crazy is so jarring because last year was the record low point for stock volatility, with the Chicago Board Options Exchange Volatility Index, or VIX, at 8.56 in November. Then starting out in late January, the market freaked out over perceived threats of inflation, faster-than-expected interest rate hikes, and weakness in the previously burgeoning tech sector.

As the market slumped, trading reached a crescendo. On Feb. 6, according to the CBOE, the VIX hit a record high of 50.3 during the day and ended up at 30.4 at the close.

Things seemed to settle down some by mid-April, but don’t be fooled. The halcyon single-digit days of 2017 are over, at least for the foreseeable future. The new normal of heightened volatility is here. “A sub-10 VIX is abnormal,” said Jason Browne, chief investment strategist of the FundX Investment Group.

“This was long overdue,” said Sal Bruno, chief investment officer of IndexIQ, a New York Life unit, about the rise in volatility. “When you see a long period of low volatility, you expect something to happen” to quicken the tempo. 

There’s no reason to believe another stretch of calm lies ahead. “History suggests we may not be out of the woods just yet,” wrote Brad McMillan, chief investment officer at Commonwealth Financial Network, in a research report. “Previous spikes in volatility have lasted for months, not days.”

Or longer. Volatility is off its highs, yet it sure isn’t low. Following back-to-back slides in January-February and mid-March, market prices have inched up again, while volatility has remained elevated. During this period, the VIX has closed above the 20 level on 17 occasions, versus zero times for 2017. The last 20-plus close was April 9, although volatility has remained near the long-term average of 19.4, and decidedly above the median (where one-half of the readings are above and the other half below) of 14.

Let’s look at the three reasons higher volatility is likely to stick around:

Higher interest rates. The Federal Reserve is on a campaign to push up short-term rates. At the long end of the yield curve, which the Fed has little control over, the benchmark 10-year Treasury note is poised to go above 3%, amid concerns over rising inflation.

All this can translate to more stock volatility. One big reason: Borrowing, the life blood of many companies, will then cost more. Increased debt service could eat into net income, which would make stocks less appealing. “That makes the pain threshold worse,” said Randy Watts, chief investment strategist at William O’Neil. Also, higher bond yields encourage investors to abandon stocks for fixed-income, putting downward pressure on equity prices.

Index investing’s popularity. For the past few years, the trend has been for investors to yank money out of actively managed mutual funds in favor of index funds, which track benchmarks like the S&P 500. In 2017, Morningstar data shows, they pulled $7 billion out of active funds and put $692 billion into index portfolios.

The enticement for investors is that index funds, also known as passive investments, are cheaper. They run on auto-pilot matching their benchmarks, thus avoiding the need for armies of expensive managers and analysts. Plus, year after year, the majority of active managers fail to beat the indexes.

The upshot is more churning of stocks. Passive funds, now representing 36% of fund assets, up from 17% a decade ago, need to buy and sell shares to maintain their matches with the benchmarks. In a selloff, tons of index-held shares would be thrown onto the market, making a bad situation worse.

Baby boomers get out. Not just out of the workforce, by retiring, but out of the stock market. An estimated 10,000 boomers retire daily in the US. Their risk tolerance retires with them, which will result in their unloading stocks.

The standard investment advice is that, when you retire, you should dump your equity holdings and put the money into presumably less-risky bonds. “In 2000, they were 45” and wanted to build wealth through stocks, said David Ader, chief macro strategist at Informa Financial Intelligence. “In 2018, they want to sell their stocks.” That means a demographic problem for the market.

One piece of good news: More rapid volatility is not always a bearish sign for the market. “While we saw extended volatility in 2015–2016, and even in 2011, markets in the end did not fall much further than we have already seen,” Commonwealth’s McMillan observed. “Volatility does not equate to a bear market, although it can be a prelude to one.”

The recent faster volatility didn’t change the market’s leadership, which still is with the tech stocks. The information technology sector of the S&P 500 has the largest market cap at just above $9 trillion, and over the past three months has lost the least (minus 3.83%) other than energy (off 3.37%), a likely ephemeral comeback fueled by suddenly surging oil prices. Of the top 10 performers in the Dow Jones Industrial Average over the past three months, four were tech, with chipmaker Intel as the No. 1 gainer.

The biggest losers in this spell of faster volatility: instruments that wagered on a continued low VIX. For instance, an exchange-traded fund called the ProShares Short VIX Short-Term Futures shed 90% of its value in early February and hasn’t retraced any of the losses.

These funds’ sponsors didn’t see volatility revving up. But that’s what always eventually happens. “Volatility,” said George Schultze, founder of Schultze Asset Management, “is always lurking around the corner.”