- Bernstein analysts studied all the major episodes of volatility that have occurred since 1900 and came away with five lessons on the biggest drivers of stock-market crashes.
- They also dispelled some widely held myths about the impact of the economy on the stock market.
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As an investor in stocks, there’s no escaping volatility.
Quick gains and painful losses are part and parcel of the game and have been for over a century.
That’s why it is crucial to understand what drives market volatility — and what doesn’t. To help you with that, analysts at Bernstein divvied up various eras since 1900 to unravel how various periods compared, and more importantly, what the differences can inform you about future volatility.
The overarching takeaway for the modern era from Bernstein’s Philipp Carlsson-Szlezak is that volatility is more prevalent at both extremes, high and low. For proof of this assertion, simply cast your mind back to 2017, the calmest year in decades as measured by the CBOE Volatility Index. That year was followed by the biggest one-day spike in the same gauge barely two months into 2018.
Without further ado, here are the five biggest lessons investors should keep in mind about volatility:
1. Volatility averages are flawed.
Carlsson-Szlezak begins by observing a historical paradox: The average stock-market volatility over the past 30 years was identical to the average from 1900 through the Great Depression. To give you a picture of how different both time periods were, he noted that the economy was in recession 42% of the time through the Great Depression versus 9% of the time over the last 30 years.
So what gives? The similar averages hide the fact that the distribution of volatility is more skewed today towards extremes, meaning there’s both more low volatility and more high volatility.
"In both cases panics amid a dearth of liquidity drove extreme volatility," he said.
2. The economy does not drive extreme volatility.
If you believe the maxim that the stock market is not the economy, you’ll love this lesson from Bernstein.
It basically shows that there’s no direct correlation between depression-like economic conditions and the level of volatility in the stock market.
Proof for this lesson comes straight from two of the worst economic crises in modern history: the Great Depression and the Great Recession. Bernstein found that the highest volatility events in October 1929 and October 2018 were almost exactly the same — realized volatility shot up to within the 80th percentile rank of history in both eras.
If volatility were simply driven by economic fundamentals, you’d expect it to be higher during the Depression. Instead, the research shows that the worst volatility is driven more by factors like forced selling, panic, and banking stability, and yes, a dearth of liquidity.
3. It’s possible to have a bad economy and low volatility.
This is related to the lesson above, and draws on the era between 1966 and 1994 that saw wild surges in inflation — including the 1980s recession caused by the Federal Reserve’s struggle to keep prices in check. Despite these challenges, volatility was low much of the time.
To explain why, Carlsson-Szlezak made a distinction between the financial ecosystems and economic ecosystems of both eras. Although the economy flailed between 1966 and 1994, the financial system was still relatively stable and the asset bubbles that would poison the system in the early 21st century were still nonexistent.
However, there’s an elephant in the room for the 1966-1994 era: Black Monday on October 19, 1987. But then, this market tragedy had little to do with the economy, and much to do with portfolio insurance and the forced selling that it triggered.
4. Geopolitical tension does not guarantee higher volatility.
For this lesson, Bernstein turns to one of the most violent stretches of the 20th century — from 1942-1965 — when the US waged World War 2, the Korean War, and the Vietnam War.
And yet, volatility during this period was extraordinarily low, not even hitting the 50th percentile as the chart below shows.
As disruptive as the wars during that era were, investors could count on a healthy banking system with low leverage and a stable foreign exchange rate ushered in by the Bretton Woods system, Carlsson-Szlezak said. These factors and others kept volatility low on average.
5. Geopolitics and economic fundamentals get more attention than they deserve.
Carlsson-Szlezak’s final lesson essentially ties together the aforementioned ones.
If geopolitics and the economy truly generate less volatility than is perceived, then maybe it’s high time investors paid less attention to both.
"The various episodes point to the greater influence of the financial ecosystem in shaping volatility, particularly extreme volatility: liquidity, market structure, leverage, the banking system, elastic investors, and other financial risks," Carlsson-Szlezak said.
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