A look into market volatility compared to history
US equities saw an increasing number of sharp reversals in performance last year, but we caution against extrapolating this to mean that a change of trend is around the corner.
Conventional investing wisdom has it that one should ignore the daily moves of the market, but it is equally important to distinguish between random fluctuations and a long-term pattern. An engaging question arising from one of our interactive team meetings was whether markets have recently been choppier than historically.
If you have been staring at a financial screen every day and constantly reading the news, you could be forgiven for thinking so, but what does the data say? As my colleague Tim Armitage would say, we are in the midst of a data science revolution and if the data exists, test it. However, there is no single and intuitive definition of market choppiness, hence we set out to create a custom metric.
We define choppiness as whether markets have been oscillating between positive and negative returns. The opposite of market choppiness is the existence of strong trends, that is, the persistence of positive or negative returns. We define a strong reversal as a gain (loss) of 4% or more over three months followed by a 4% loss (gain), and a strong trend as gain (loss) of 4% or more over three months, followed by a 4% gain (loss).
The number of sharp reversals in US markets over the last year has ticked up and is now at one of its highest levels over the last 29 years. This tells us that the S&P 500 has indeed been choppier in the recent past, which would partly explain why momentum strategies have been struggling over the last year.
Another interesting observation here is that we rarely see a combination of rising reversals and falling trends, with one such instance being from 1999 to 2002. However, compared to then, the number of strong trends is now lower than sharp reversals. This starkly portrays the tug-of-war between positive and negative factors when competing for investor focus in US equity markets over the last few years.
Compellingly, the conclusion is different for European stock markets. Over the last year, we have seen a fall in the both the number of sharp reversals and trends. Both are at one of their lowest levels in the last 29 years. Rather than investor focus oscillating between positive and negative factors as it has in the US, in European stock markets the positives and negatives have been averaged out to a collective 'meh'.
It wasn't always so. Please allow me to draw your attention to the financial crisis and its aftermath with regards to both the US and European markets. Unsurprisingly, we saw both an increase in the number of sharp reversals and strong trends, which portrays the panic behaviour that gripped markets at the time. However, the number of strong trends for Europe peaked at a lower number than the US markets over the last ten years, which is a function of the many mini-crises that have gripped the continent.
Well, this is all very interesting, but what does it really tell us?
For starters, our new measure allows us to assess the type of market environment we have been in, which is useful context for understanding recent performance (especially of momentum strategies)
- For starters, our new measure allows us to assess the type of market environment we have been in, which is useful context for understanding recent performance (especially of momentum strategies)
- The analysis also reiterates the importance of distinguishing between different stock markets before drawing any conclusion. Although markets are correlated, they are driven by different factors and sentiment
- Over the long term, there are more 'trends' than 'chops'. This cautions investors against assuming that markets are more likely to fall (rise) just because they have been strong (weak) lately, and therefore against extrapolating the recent performance of momentum strategies
- We believe that portfolios should be designed to take advantage of both choppy and trending market conditions (through rebalancing and momentum strategies)
So what's more important for investors isn’t the day-to-day market waves - it’s avoiding the rocks and using the power of compounding when setting sail.