On Friday, July 8, the S&P 500 Index closed up 1.53 per cent. Until Friday, that was the last time the benchmark moved by more than one percentage point in a day, up or down.
Joe Amato drew attention to this two weeks ago. He was concerned because exceptional periods of low market volatility tend to store up risk, leaving investors increasingly exposed to the event that eventually blows assets out of their tight trading ranges.
At the time, this calm had persisted for 34 trading sessions. Friday’s close finally brought an end to the run, which had reached 43 sessions by Thursday.
So much risk, so little caution
Low volatility has characterised much of 2016. There have been only 12 1 per cent-plus sessions since March 11, notwithstanding various central-bank experiments, an attempted coup in Turkey, the impeachment of the President of Brazil, and Brexit.
And the fun isn’t over yet. Before 2016 is out, we’ll know the result of the most divisive US presidential election in recent times. We’ll have endured a vote in Italy that was designed to make government more streamlined, but which has warped into a referendum on Prime Minister Matteo Renzi’s administration and Eurozone membership.
Both of these races are close, with the potential for profoundly market-unfriendly outcomes. Earnings season could disappoint again, and the Fed may deliver its long-awaited second rate hike. Amid all this, assets are priced for perfection: Volatility is low, bond yields are low, equities are fully valued (in the US, at least).
The web of high correlation and low volatility …
This week, I want to add to these observations about low volatility by drawing attention to the levels of market correlation that go with it.
Our quantitative team paints a vivid picture of this with its “spanning tree” analysis of markets. These spanning trees show different asset markets as circles joined together by lines representing vectors of correlation: When they look like chains or strings of pearls, that’s an indication that markets are not particularly correlated with any one driver of systemic risk.
By contrast, when they look like stars, flowers or spider webs, that suggests market movements are tightly coupled, with the market at the centre driving systemic risk.
The spanning tree has looked like a spider’s web for a good 18 months. To sum it all up, we face a number of risky events that could impact financial markets, and those markets are both priced for perfection and tightly correlated: The potential for one event to reverberate through the entire web is high.
… And the spider at the centre of that web
What is the spider at the centre of this web of market relationships? Eighteen months ago it was China. Nine months ago it was oil. Currently it is US equities. That suggests the whole market is watching US stocks and the fundamental data feeding them for signs as to whether it’s OK to take a position on the web of risks.
It also suggests that a lot more rides on US earnings than the level of the S&P 500. If poor earnings make US equities lurch, it will be as if that spider is clambering across its web in pursuit of prey. That doesn’t necessarily mean all assets would fall in value, but it may mean all assets react to the shock, just as all parts of the web vibrate as the spider strikes.
One might expect equities and the US dollar to sell off, bond yields to fall, and gold, oil and emerging markets to rise, for example. From today’s environment in which all asset values grind slowly upwards in sync with US equities, the shock could take us to a regime of higher volatility with a much wider range of dispersion.
We think the lessons from the spanning tree analysis are pretty clear. Stay diversified. Be prepared to be opportunistic. Long/short strategies, risk-premium strategies and other market-neutral or relative value approaches to investing — which have the potential to eke out positive returns in this tightly correlated environment while offering attractive upside potential should volatility strike — may work better than straightforward “beta,” or market-oriented, strategies.
Most importantly, keep an eye on the spider at the centre of the web. When it moves, some overexposed or under-diversified investors could get eaten. You needn’t be one of them.
Erik L. Knutzen is a Managing Director, and Multi-Asset Class Chief Investment Officer at Neuberger Berman