Coming to grips with market volatility

Despite the apparent calm in global markets, investors should not underestimate the potentially disruptive force of volatility.  

Volatility has been trending lower since late 2011, as markets moved higher. But in July 2014, markets recorded a slight jump in volatility. Since then, there has been a great deal of discussion and analysis about what will happen next and how investors should position themselves to cope with future volatility.  

We believe that low volatility over a long period, especially in the current market conditions, can serve as an indicator of elevated market risk. 

The question for financial advisers is: How can your clients position themselves to take some of this volatility risk off the table? 

The danger for investors is that they get nervous about future volatility and start to fear the worst. It is then that they can make the wrong choices for the long-term. 

There is a clear relationship between volatility and market performance. 

Quite simply, when volatility spikes, the market usually moves dramatically.  

The most recent period has been something of an aberration. Since late 2011, volatility has trended lower as the market has witnessed strong and steady performance, rising to break through new highs again and again. And although there was a volatility spike in July, relatively speaking, the bounce was quite small. 

So what exactly is volatility, and how is it measured? 

To understand the relationship between markets movements and volatility, it is necessary to understand the role of the VIX. 

The VIX, or CBOE Volatility Index, is run by the Chicago Board Options Exchange (CBOE), and is considered "the world's barometer for market volatility".  Since its introduction in 1993, the VIX has gained a reputation for being the main barometer of investor sentiment. 

Basically, the VIX measures the major US market's near-term volatility by collating and analysing S&P 500 stock index option prices.   

To do this, the VIX measures the amount of volatility contained in option premiums at a specific moment in time. Originally, it used a weighted average of the implied volatility of the at-the-money and near-the-money options on the S&P 100 index. However, its composition was altered in 2003 to broaden its effectiveness.  From this point, the VIX was calculated using the implied volatility on a greater number of options over the S&P 500 index. 

The VIX is quoted as a number between 0 and 100. The number then represents the anticipated percentage movement -- both up and down -- in the S&P 500 index over the next 30 days.  For example, a VIX reading of 12 would mean, based upon the implied volatility in the options on the S&P 500 index in the first and the second months, the index is expected to move within a range of one percent (12 divided by 12 months) over the next 30 days. 

However, rather than using the VIX as a predictive tool for future market movements, it is perhaps best understood as a measure of the amount of fear and risk in markets. In fact it is often referred to as the "fear index".  

For example, on the day of the Boston marathon bombing, on 15 April 2013, the VIX jumped 43 per cent.  But the stock market itself barely faltered, falling less than 0.7 per cent over the following days, before starting its upward trajectory again.  

On this occasion, the VIX simply demonstrated the heightened level of fear in the market rather than proving itself as a predictive tool for when the next correction or crash might happen. 

When dealing with market volatility, it is vital that investors look through the immediate data to ensure they manage risk and achieve a smoother return. 

A good example of this is the US energy industry, which has seen strong recent growth as a result of the rise in shale oil, as well as other unconventional energy sources. 

For investors, the immediate story is one of growth and investment potential, as well as related benefits such as the boost to the domestic economy, geographic wealth diversification, reduced foreign policy risk and increased local manufacturing competitiveness.  

However, we believe the true story is less compelling. One clue is that most US shale wells will become almost obsolete within five years. 

As a result, producers will need to spend more and more on drilling more wells to grow, or maintain supply. This creates an unsettling investment dynamic and we believe the industry is already approaching a tipping point.   

We believe earnings for companies in this area will inevitably decline in the medium to long term, but this is not reflected in analyst ratings, and investors should be aware of this risk. 

Despite the continuing good performance by equity markets, we are seeing growing levels of fear from investors. 

Much of the fear in markets over the last few months has been generated by geopolitical uncertainty, particularly in the Middle East and Ukraine. As well, US concerns about the timeframe for rising interest rates has also been causing some concern. 

Investors will need to wait and see what the outcome is of the extraordinary events in the Middle East and the Ukraine, as well as whether the US market will continue to show signs of volatility.   

One factor that may lead to increased volatility is potentially disappointing US corporate earnings anticipated later this year. Consensus expectations have anticipated earnings per share to increase approximately 14 per cent for both 2014 and 2015. But, given the long-term trend is around six per cent, we see this as an unlikely outcome, especially with the backdrop of a rising rates environment. 

Chad Padowitz is chief investment officer at Wingate Asset Management.