Low 20-day historical volatility and outperformance is bad combination for the SPX
The S&P 500 Index (SPX) has been calm lately, as measured by the 20-day historical volatility (HV). The 20-day HV reading has slipped into the lowest quintile of readings since 1950, as indicated by the black line on the chart below.
Such low volatility can be interpreted in a couple of different ways: In the context of a rising market, it may signal market stability, suggesting the uptrend is likely to continue. Conversely, it could serve as a contrarian indicator, hinting at investor complacency and raising the risk of underperformance or a sharp reversal.
This week, I will examine historical data to determine which interpretation tends to be correct.
Historical Volatility Brackets
First, I am looking at how stocks have generally performed based on 20-day HV. The table below uses SPX data since 1950, summarizing the returns over the next month based on the volatility reading.
The current reading of about 7.8% is in that first bracket of the lowest readings. Unfortunately, the average return for the SPX over the next month is the lowest in that bracket, sitting at 0.42%. The percentage positive is at 60%, but that stat does not vary much between brackets.
The main cause of the low average return is the lack of upside. The average positive return when HV is below 8.1% is 2.4%, which is significantly lower than the average positive returns at the higher HV ranges.
I wanted to see if this tendency still held focusing on more recent data, so I focused on data since 2010. The table below presents the same analysis as before, but limited to this period.
The results show the market has performed even worse during extremely low volatility environments. When the SPX’s HV dripped below 8.1%, the average return in the next month was just 0.33%. This is lower than the average return for the same low-volatility bracket in the full dataset, even though overall market performance has improved in recent years. All other volatility brackets show higher average returns after 2010, compared to the data going back to 1950.
Low Historic Volatility Readings During Uptrends
The SPX is up about 30% over the past 12 months. Below I have a similar analysis to the one above, but I’m only looking at times at which the SPX was up 20% or more in the year prior.
This next table looks at that data since 1950, and it keeps getting worse. When the 20-day HV reading for the SPX was below 8.1% and it had gained at least 20% in the year before, the index averaged a loss of 0.12% over the next month, with less than half of the returns positive. This could be a cause for concern in our current situation.
Finally, here’s the data for the brackets since 2010 when the SPX has gained at least 20% over the year prior. The returns are more mixed, with the fourth bracket being the worst performer by average returns. The extremely low volatility bracket shows an average return of -0.23%, with just half of the returns positive.
