Markets, Matter, and Risk

Risk is conserved.

S&P 500 member returns, 2-6-18. Source: Finviz

That’s what I thought as I looked at the recent sell-off. Ever since the recovery of the oil patch in March of 2016, the markets have seemed like a one-way, upward bet. Normal volatility has been suppressed. For decades, the market returns averaged 8%, with 15% variance. That is, most returns were spread between 22% and negative 7%. While the average was pretty reliable, any particular year could happen to fall between really positive or slightly negative.

This measure of volatility is inherent to the kinds of securities we hold, and it’s based on the underlying business. Bonds represent a senior claim on a business’s cash flow. If the company doesn’t pay what it owes you, you – and a posse of other bondholders – can get a court order, enforced by law, to take control of the company’s assets and deliver your claim on the firm. That’s what Lehman Brother’s bondholders got, after the company went bankrupt.

Stocks are a residual claim on cash. There’s no legally enforceable contract, the investors just benefit from a voluntary dividend and any growth. That’s why bond market volatility is usually a third of stock market volatility. Bond returns are lower, and their variability is lower. What’s more, if you hold a bond until it matures and nothing goes terribly wrong, you know what you’re going to earn. Stocks are more like Forrest Gump’s box of chocolates: you never know what you’re going to get.

Volatility is a good proxy for risk. There are lots of definitions of risk. My personal favorite is the chance of something going wrong. When you own a US Treasury bond, there are fewer chances of something going wrong than if you have a stake in a limited partnership focusing on early-stage restaurant start-ups. The degree of riskiness is inherent in the investment. When you buy a publicly traded investment, lower prices mean something has gone wrong – at least for you. Volatility quantifies the jumpiness in prices.

12-month histogram of historic S&P 500 volatility. Source: Bloomberg

For the past year, volatility has been suppressed. Equity market volatility has been more like bond market volatility, and bond volatility has been even lower. Stocks have seemed like a one-way bet higher. Risk management has been for losers.

With volatility so low lately, investors could be forgiven for asking, “What could go wrong?” That’s what the market has been telling them. Well, now we know what can go wrong. A market built on the premise of strong earnings, low inflation, and low interest rates justifying higher multiples can be derailed by the premise of higher wage growth leading to higher inflation and higher rates from the Fed. Risk hasn’t been eliminated, as the 5-fold spike in volatility in the last week would indicate. Historic volatility moved from 5% to 25%; implied volatility, a measure that’s part of options pricing, went from 10% to 50%.

Implied volatility index. Source: Bloomberg:

Risk can’t be eliminated, just suppressed from time to time, or shifted around. The conservation of risk in the markets is like the conservation of matter in the universe. It may not be always visible – the market may have “dark volatility” just like the universe has “dark matter.” But eventually, it reappears. Risk is conserved.

Douglas R. Tengdin, CFA

By |2018-02-06T07:39:25-04:00February 6th, 2018|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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