It wasn't hard to sense the unease that gripped traders this summer as U.S. stocks meandered through their calmest period ever. As it turns out, they were right to be on edge.
Markets were finally shocked out of their torpor when $600-billion was erased from the value of shares on Sept. 9. The eruption was notable not only for its force, but also as a painful reminder that such episodes are becoming much more frequent. In the last two years there have been five similarly extreme shifts in volatility -- as many as occurred in the prior two decades, according to data complied by Deutsche Bank AG and Bloomberg.
In many ways, the gyrations highlight the nervous tension underlying the 7 1/2-year bull market that is now the second-longest on record. It's not hard to see why, with central banks questioning the benefits of pumping billions of dollars of free money into the pockets of investors every month with little to show for it in the way of economic growth, share valuations approaching record highs and the role increasing for computerized funds that use volatility as a trading signal.
"When you look around the world, it's hard to find very positive growth drivers, and at the same time you can find a lot of things that could go wrong," said Jimmy Chang, chief investment strategist at Rockefeller & Co. in New York, where the firm oversees about $15-billion. "Every time we're running into a crisis mode, it really takes the central banks to step in to calm the market. There is a general lack of conviction and people are taking it one day at a time."
Repeated thrashings have taken a toll on the psychology of individual investors, who last week yanked $7-billion from U.S. equity funds in the latest rerun of bearishness that has persisted ever since the bull market began in March 2009. While some see the skepticism as good, dousing euphoria and christening future buyers, it's a break from past rallies when smaller investors were consistently engaged.
The Deutsche Bank study examined instances of rapid mood transitions in U.S. equities, counting times when realized volatility in the S&P 500 surged from a very low level, below 10, to above 20 within six weeks. On that basis, the market has seen its prevailing calm shattered five times since 2014, matching the total in the preceding 20 years - a stretch that encompasses two full-blown bear markets.
Just such a rupture occurred earlier this month as speculation the Bank of Japan would change its approach to monetary stimulus was followed by European Central Bank President Mario Draghi questioning the benefits of more easing. A warning by Boston Fed President Eric Rosengren against waiting too long to raise rates finally knocked the S&P 500 out of a 40-day trading range, sending the index down 2.5 per cent on Sept. 9 and pushing the CBOE Volatility Index up 40 per cent.
That episode came just two months after an equally dramatic eruption in late June, when the U.K. voted to leave the European Union. China's currency devaluation in August 2015 was a third, when the VIX had its largest two-day surge on record, a 113 percent jump that pushed the options-derived gauge of investor dread to a four-year high.
The VIX jumped 17 per cent at 9:45 a.m. in New York, while the S&P 500 slid 0.7 per cent.
While bouts of volatility are more pronounced, so is the market's propensity to settle down. Days following the Brexit vote, swings subsided after the ECB and Bank of England indicated they were prepared to loosen policy to deal with the fallout. The S&P 500 dropped 5.3 per cent over two days, only to rally the next four and erase the entire plunge two weeks later.
"Having central banks as a backstop is very constructive, but we're in a late inning of a bull market and expansion, and investors are quicker to become fearful," said Hank Smith, who helps manage $8-billion as chief investment officer at Haverford Trust Co. in Radnor, Pa. "There is more reaction around either data points or geopolitical events and that takes on a sense of greater significance and hence translates into more volatility."
That shocks are clustering suggests to some analysts they're being driven by new kinds of funds, specifically those that buy and sell shares based on the trend of market volatility. Managers of these so-called quantitative funds typically unload big slugs of equities, usually through index futures, as sell-offs unfold, according to Rocky Fishman, an equity derivatives strategist at Deutsche Bank. Volatility control funds have seen their assets go from zero to $200-billion in just a few years, he estimates.
"The quick transition from low volatility to high volatility is what they really contribute to," Mr. Fishman said. "It's almost like the concept of volatility regime itself is becoming passe, where we don't go through years of being in either low vol or high vol. Volatility itself changes faster."
Despite the willingness of central banks to step in at any sign of trouble, the risk of higher volatility is growing amid the uncertainty over Fed policy and presidential elections, according to Harald Hvideberg, a St. Petersburg-based portfolio manager at Eagle Asset Management, which oversees about $31 billion. Moreover, the economy has yet to show signs of strengthening enough to stem a year-long profit decline, he said.
Expanding at an average 1.8 per cent a quarter since 2009, gross domestic product is stuck in its weakest recovery from a recession since World War II. Even that level of growth may not be achieved in 2016 as economists forecast GDP to expand 1.5 percent this quarter and 1.8 percent in the final three months of the year.
The sluggishness has started weighing on earnings as companies run out of options to reduce costs with sales almost unchanged. S&P 500 profits are poised to fall a sixth straight time this quarter, according to analysts estimates compiled by Bloomberg. At 18 times forecast earnings, the index is trading near the highest multiple in more than a decade.
"There is some gas left in this cycle, but there is so much skepticism out there," said Mr. Hvideberg. "At the slightest hint of something going wrong, the market is skittish."