Volatility Ahead

Market Moves

The S&P 500 (SPX) closed 1% higher as buyers, for the most part, resumed the demand for stocks they showed throughout 2019. Despite the optimistic start for 2020, investors took profits in some industry groups, such as retail stores, demonstrating subtle signals that market turbulence may be just over the horizon.

The move higher today is seen as a continuation of the trend evident in the fourth quarter of 2019, which capped off strong returns for the year. It is worth pointing out just how unusually good market returns were last year. The chart below shows that the S&P 500's most recent annual return of around 29% compares well to other years noted in its 90-year history. Only 13 years in the past century featured better percentage returns. When measured compared to volatility, 2019 moves higher up the list, with only eight years doing better. 

The only year in the past two decades that showed better returns was the year 2013. And just as 2014 featured greater volatility than 2013, it's a good bet that 2020 will feature more volatility than the unusually low fluctuation found throughout much of 2019.

Low Volatility in 2019 Could Lull Investors into Complacency

When investors exhibit strong demand for buying stock as their preferred investment, then chart watchers typically notice a lower degree of fluctuation in prices. This decreased volatility occurs because many investors buy stocks and hold on to them. They prefer to be patient, and as they remain so, prices go higher with fewer and fewer dramatic drops along the way.

Because 2020 is an election year and because many global trade and political issues remain unsolved, it is likely that the markets will react to any number of scary headlines in the coming year. Investors would do well to realize that their investments may generate a greater degree of price fluctuation. The chart below gives an indication of just how unusual this period of low volatility is compared to years in the past. And yet the end of the year showed that option sellers were reluctant to give ground on risk pricing.

Option Sellers Still Concerned About Falling Prices Ahead

The comparison between the Volatility Index (VIX) and the S&P 500 Index showed a surprising and subtle indication that share prices may be in for some unexpected volatility. Over the past 11 sessions, the VIX has trended higher, while the S&P 500 has done the same. The VIX is usually negatively correlated with the S&P 500, so that when prices drop, the VIX goes higher. That both indexes should be trending higher at the same time is an unusual signal that generally portends greater price fluctuation, primarily with falling prices.

The price levels of the VIX are determined by option prices, which in turn are determined by market makers in the options market who typically charge higher prices when they see a greater demand for put options (investors use put options to protect their portfolios from falling prices).

The Bottom Line

Stocks closed strongly higher today to start 2020 in a move that seemed to be a continuation of the excellent investor conditions that existed in 2019. Investors would do well to be aware that price fluctuations (including price drops and strong price recovery shortly thereafter) could occur more frequently in 2020 than in the previous year.

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