In these volatile times, many investors are receptive to volatility reduction products.
However, research conducted by ICON Advisers President Craig Callahan and C. Thomas Howard, professor of finance at the University of Denver and co-founder of ICON affiliate AthenaInvest, has shown that while higher- than-average weekly market volatility occurs concurrently with lower-than- average or negative returns, this phase is frequently soon followed by lower volatility and higher-than-average returns. Stock market conditions change through time, and recent behavior often does not continue into the future. That said, it is worth looking at the patterns when deciding how to approach markets immediately following a prolonged period of volatility.
First, it's important to define and measure volatility. One way to define it is the standard deviation of the trailing 13-week moves in the S&P 500.
Examining this measure of volatility over a long historic period, from Jan. 1, 1928, to Dec. 2, 2011, a number of peaks stand out - notably 1929 (post-crash), 1932, 1933, 1938 and 1940. In the early 1960s, the market experienced bursts of volatility, some as part of bear market bottoms (1974, 1982, 2002, 2009), while others were associated with particular events (Black Monday in 1987, Asian Contagion in 1998 and the Eurozone debt issues in 2010).
Only twice has the market experienced above-average spikes three years in a row, both of which occurred within the last 11 years. Altogether, ICON's research identified 18 extreme volatility spikes during this period.
The table above describes economic conditions surrounding these 18 spikes and the subsequent 52-week return of the S&P 500. The trend is striking: The average of all the subsequent 52-week returns following a volatility peak shown on the chart is 11.4%. In addition, returns in 74% of these 52-week periods following a volatility spike are positive.
Investors shell-shocked by a recent period of extreme volatility may focus on avoiding exposure to volatility at all costs. However, those using the rear-view mirror to reduce volatility may risk long-term underperformance.