Get Ready for a Few Weeks to Months of Higher Volatility

The last few months witnessed the lowest period of volatility in decades for the S&P 500. Until Friday, we hadn’t seen so much as a 1% (daily) change in over 2 months. Bollinger Bands are a technical indicator that measure market volatility. Here’s how they work (take a deep breath if reading this aloud): they are plotted as the standard deviation of price changes over the past 20 days, plus and minus 2 standard deviations around the 20-day average (phew). If that’s a little hard to remember, there are plenty of charting packages out there that automatically plot the bands for you. The percentage difference between the upper and lower two standard deviation band (called “bandwidth”) is featured on the bottom of today’s chart with the scale in percentage terms. For comparison purposes, the average monthly standard deviation for the S&P 500 is 3.5% going back to the mid 1920s. A reading below 2% is considered extremely low volatility, and readings above 15% are considered very high.

I have highlighted on the chart the periods where volatility dropped below 2%, and observed the price action following these extreme low volatility periods. In virtually all periods (there are always some exceptions), the subsequent increase in volatility has been accompanied by market weakness. While we know some degree of market weakness is likely, we do not know the magnitude or duration of the weakness. Looking back to 2009 we have seen corrections ranging between just a few percent, to as much as about 15%. The trendline off the Feb and June 2016 lows projects support in the 2100 area this week. A weekly close below that trendline would suggest this correction is likely closer to the higher end of the range.

sp500-vol

The psychology of Mr. Market is that it tends to inflict the most pain on the most people at extremes. Squeezing shorts into the market at tops, and causing investors to bail on their long positions at the bottom (selling low). The biggest stress for the bulls would come if the lows of the past few years around 1800 on the S&P 500 were to break. A break of that multi-year support zone would suggest a move even lower than the typical range we’re looking at.

From previous educational segments you’ll recall that long-term trailing earnings for the S&P 500 are now trading at a price-to-earnings (P/E) multiple of approx 16.5. The current trailing earnings is 106.49 for a trailing multiple of 20 at Friday’s close. If earnings do not grow over the next two quarters, valuation support at a 16.5 multiple is 16.5 x 106.49 = 1757. In a recession, earnings typically fall about 10% so 16.5 x 95.84 = 1581, which is the area of the previous two highs in 2000 and in 2007. The current 12-month forward expectation for earnings growth in a slowing world is an astounding 124.09 and looking out into the end of 2018 148.46. That would put the S&P 500 at fair value of 2450 = 16.5 x 148.46 (if you believe that earnings can grow at what would be the fastest pace in history this late in an economic cycle).

The more likely best-case scenario is for markets to chop around sideways for a few more years, as earnings and economic growth is challenged. While the worst case is a multiple contraction over the next year or so that is more in line with slowing growth trends. More defensive portfolio strategies are prudent until valuations are better and future expectations are more realistic.

Watch the segment on BNN.ca here:

http://www.bnn.ca/bermans-call/berman-s-call-part-three-educational-segment~949343

 

Share your thoughts and comments