Where did all the volatility go?

The CEO of Goldman Sachs, Lloyd Blankfein, had a very good quote this week that he told his clients. He said. “It’s always uncertain when you’re living in it and so simple and sure when you’re looking back.”

In this uncertain market, many investors expected a much more volatile market. Most 2017 market outlooks predicted a volatile market this year. I even anticipated a bumpier ride. But the exact opposite has occurred. The markets have now gone 42 trading days without a 1% move. This has broken a 40-year record! The CBOE’s Volatility Index, also known as the VIX and commonly referred to as the “fear index,” is at a decade low.

The volatility is so low that many seasoned traders are getting nervous. The thinking goes if markets go to one extreme, it will only be a matter of time before the pendulum swings the other way.

The textbook definition of risk in investing is called standard deviation. Standard deviation measures market volatility, and the wider the range, the greater the risk. Today’s measure of risk would show a market that is not very risky. If markets were moving outside of the 1% range, standard deviation would be high. Stocks would be considered riskier and there would be a greater potential for gain as well as loss. In 2008, when stocks were down more than 50%, standard deviation was high, and stocks would be viewed as extremely risky. This also proved to be wildly incorrect as stocks were the buy of a lifetime.

This standard deviation measure of risk is flawed because markets do not follow a pattern of a normal distribution. Rather returns are not normal, but skewed, and have fatter tails. The fat tails indicate that there is a probability, which may be small, that an investment can lose a great deal of money fast.

The investment industry has moved towards investing clients in model portfolios using exchange-trade funds (ETFs) and low-cost mutual funds. Model portfolio’s, which are constructed using standard deviation, in my view, use the wrong measure of risk. Standard deviation is falsely showing much less risk in portfolios. The correct measure of risk is based on fundamental analysis and valuation. This measure of calculating the intrinsic value of a company is implying a very rich market.

The 40-year record just broken without a 1% move, might be the sign, and be so simple looking back, that everyone piling their money into the same low cost ETFs, regardless of the price they pay, was the biggest risk for markets in the last 40 years.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Please follow and like us: