black swan

Investors, prepare for a rocky decade ahead.

I have already warned on this blog that heightened market volatility is likely to continue for the remainder of the year. The truth is that markets have become more volatile in recent years, and they’re likely to remain that way throughout this decade.

Looking at weekly data, between 1982 and 2007, a period often referred to as the “Great Moderation”, the annualized volatility of the S&P 500 was approximately 15%. Since 2008, however, the annualized volatility has risen to nearly 25%.

While no single explanation fully captures why volatility has risen, in my view the rise in equity market volatility can primarily be attributed to a rise in economic volatility. Work done by my colleague Daniel Morillo demonstrates that the volatility of financial assets is closely correlated with the volatility of the underlying economy. In less stable economic environments in which recessions are more frequent and economic measures more volatile, financial assets tend to be more volatile as well.

And since the most recent recession began in 2008, the economies of most developed countries have simply been less stable then they used to be, as reflected in the seemingly out-of-the-ordinary “Black Swan”-type economic events that have occurred in recent years. In fact, over the last few years, developed market economic volatility has increased by almost any measure. In the United States, inflation is more volatile, industrial production is more volatile and overall consumption is less stable. In Europe the situation is even worse. For example, since 2008, European-wide industrial production is approximately 80% more volatile than it was between 1990 and 2007.

What’s behind this newfound economic volatility? I would attribute most of it to the lingering impact of the financial bubble and accompanying deleveraging. Most developed countries are attempting to reduce their debt levels, European countries through fiscal austerity and the United States through the household and financial sectors. This deleveraging is creating significant economic headwinds, leading to less stable economies and more volatile markets.

Unfortunately, the deleveraging in the developed world is still in its early stages. Credit growth has been on an upward trajectory for roughly four decades, but deleveraging has been occurring for barely four years. European sovereigns and US households still have much more deleveraging to do. Worse, the biggest offenders – the United States and Japanese governments – have not even begun to reduce their debt burdens.

To the extent that the deleveraging cycle is likely to last throughout this decade, investors should get accustomed to more economic instability (think more Black Swans) and more market volatility.

They may also want to consider taking a defensive portfolio positioning through dividend-paying stock funds such as the iShares High Dividend Equity Fund (NYSEARCA: HDV) and minimum volatility funds such as the iShares MSCI All Country World Minimum Volatility Index Fund (NYSEARCA: ACWV).

 

Bloomberg:

There is no guarantee that dividend funds will pay dividends.
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. The Minimum Volatility funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.