There are no short cuts to easy profits, but sometimes Mr. Market throws us a bone (or two) in our quest for strategic insight. Two examples, though hardly the only ones, come by way of reviewing correlation and volatility histories. We surveyed correlations last week, and today we revisit volatility, as per our chart below, which graphs rolling three-year volatilities of monthly total returns back to September 1994.
The obvious trend is that there is one, or so it appears. Lulls in vol tend to be followed by surges, and then lulls, and round and round we go. It’s all obvious in hindsight, of course, but dissecting where we are in real time and how long it will last (or not) is always more obscure.
Meanwhile, we’re constantly fighting our own biases. That’s partly because the mind likes to extrapolate recent activity far into the future. Back in the late-1990s, the calm in volatility readings was thought to be the dawn of a new era in smooth and high returns in stocks and other risky assets. Such thinking prevailed right up until the idea was beheaded in the crash of 2000-2002, a reversal of fortunes that was accompanied by a spike in vol.
Something similar unfolded during 2003-2007, when returns generally were strong and standard deviations were low. Once again, it was all too easy to believe that the trend would last. It didn’t, leading to a collapse in returns and a swelling in vol.
It’s always hazardous to speculate on when a current cycle will end and a new one will begin. Nonetheless, we can and should observe cycles for what they are: finite. The one that now has the world by the neck may appear set to roll on indefinitely, but that is an illusion. This too shall pass, although the timing, as always, is unclear.