Do Surges In Volatility Precede Market Reversals?

October has often been referred to as the most horrible month for stocks, and this past October was no different.  We saw tremendous losses across all global markets; not to mention gut wrenching volatility that made even the most seasoned investors uneasy.   This extreme volatility was the aspect of the past month that was most interesting to me and it was interesting to learn that there have been previous instances of volatility that were just as extreme.

Historically speaking, the volatility we’ve witnessed has not been normal. And after almost five years of below-average volatility levels, the past few weeks have felt even worse. Recently a closer look at volatility in U.S. equity markets was studied within a historical context.

Market Volatility Over The Century

The statisticians went as far back as 1900 to gather points of data on all instances when volatility significantly deviated from the historical long-term average (for you statistics gurus, that’s +/- 1 standard deviation from the norm). I’ll continue to refer to this anomaly as a “surge in volatility”.

As observed in the chart below, it is evidenced that aside from the past few weeks there have been four specific instances in history when we have seen an extreme surge in volatility – October 1929, February 1938, October 1974 and October 1987 (notice the frequency that the month of October occurs).

Based on a comparison of these historical periods, here are some observations:

  •  The increase in volatility occurs very quickly.
  •  In three out of four times, the market bottomed within one month after the initial surge in volatility (in ‘74, the market bottomed two months after the initial surge).
  •  In all but one period, the stock market was up in the 12 and 24 month periods following the surge. The exception was the period following October 1929 which stands to reason given the extraordinary economic headwinds of the era (the Great Depression).

 What does this mean for investors?

If the chart is any indication, a surge in volatility may be one indication that we are seeing the “darkest before the dawn”. It’s very important to note that this analysis isn’t meant to signal that a market bottom is around the corner. Rather, it suggests that periods of extreme volatility like the one we’re experiencing today have tended to represent important turning points in the market.

Of course the standard disclosure always applies in that “past experience is no indication of future performance”, but my view is that history is all of the information that we have to analyze.  Therefore, I take the stance that this compilation of information is better than no information at all.

I suppose that only time will tell if the extreme volatility in the equity markets during October 2008 was yet another indication of a market reversal.  

 

Chart Courtesy RBC Capital Markets

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