Priced For Perfection

This is what perfection looks like: high trailing returns and low volatility. US equities (S&P 500) are up more than 18% on an annualized total-return basis over the past five years—roughly double the long-run gain. This happy state of affairs, as usual, is accompanied by a growing number of forecasts that we’ve passed over into a new norm. But we’ve been there and done that, many times, only to find out that visions of grandeur were built on sand. Reality is a series of regime shifts, where risk and return are still stochastic processes. That’s a problem–a big problem, but only if your expectations are set in stone and your portfolio mix is rigid and inflexible.

The antidote to the current delusion starts by recalling that there is nothing new under the sun. Contrary to recent rumors, reports of the demise of greed and fear have been greatly exaggerated. But there’s a long-running habit in finance of arguing that up is down, white is black, and it’s different this time. “Stock prices have reached what looks like a permanently high plateau,” Irving Fisher announced just days ahead of the 1929 stock market crash. Fisher was a great economist, but he was a lousy investor.

Granted, the current bull market could run on for some time, perhaps longer than anyone expects. But the longer the positive momentum endures, the greater the risk, which is why risk management is still the only game in town. One of the risks we need to manage: allowing ourselves to be swept away by the increasingly appealing myth that the sinking volatility in stocks marks a new and permanent era of calm.

For the moment, that sounds like foolish advice. The CBOE Volatility Index (VIX), a market-based forecast of near-term volatility for the S&P 500, has fallen to seven-year lows. In fact, the VIX has been hovering at unusually low levels for the past two years. This looks like good news, and it is… until it isn’t.


The future’s uncertain, but some aspects of history are clear. One of the reliable lessons in the rear-view mirror is that volatility is volatile. Countless empirical studies show that “that the empirical relation between historical volatility and expected returns is negative,” as one recent paper reminded. But most investors at times like these don’t want to be reminded that there’s darkness on the other side of town, just as we’re inclined to run and hide after a market crash and ignore the distinct possibility that expected return has surged. It’s hard to be a contrarian, in large part because we’re all hard-wired to let the recent past dictate our long-term outlook. An added complication is the recognition that outliers in volatility are asymmetrical. Volatility spikes on the upside are quickly followed by reversals. By contrast, low volatility regimes tend to develop slowly and exhibit a high degree of persistence.

Does recent market action mean that it’s time to sell out of US stocks entirely? Probably not, and for the same reason that expecting the current state of financial nirvana to roll on indefinitely is misguided. Extremism in the defense of liberty may not be a political vice, but it’s deeply flawed as a foundation for earning a respectable risk premium through time.

The issue boils down to a simple question with regards to rebalancing: If not now, when? There is one empirical fact that towers above all others in the pursuit of success in the money game: buy low, sell high. The details are messy and the real-time analysis is complicated and fraught with behavioral landmines. But if you find yourself becoming more bullish as the market moves higher, you’re at risk of overlooking a simple but powerful reality in market matters: ex ante risk and return are highly unstable. You can ignore this reality if, and only if, your time horizon is forever. But if you’re not running a foundation or a pension fund, now’s a good time to get reacquainted with Hyman Minsky’s observation that stability is inherent unstable.

4 thoughts on “Priced For Perfection

  1. Pingback: Priced for Perfection – The Capital Spectator | Marty Investor

  2. Pingback: Wednesday links: low cost won | Abnormal Returns

  3. ralph

    hi james,

    “Countless empirical studies show that “that the empirical relation between historical volatility and expected returns is negative,” as one recent paper reminded. ” – doesnt this imply its a good time to be long as low volatility usually associated w high returns? then as volatility goes higher we derisk. am i understanding your post correctly?

  4. James Picerno

    Yes, you are correct. Vol is low today, which implies high returns in the future. But the question is when this reverses? We also know that vol isn’t stable, and so with vol at relatively low levels I’m wondering where we go from here.

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