After flirting with multiyear lows for most of the first quarter, equity market volatility is starting to stir from its slumber. For most of the first three months the VIX Index, a common measure of equity volatility, traded somewhere between 11 and 13, well below its historical average of 20. At one point in February, the VIX briefly dipped below 10, an extremely rare occurrence.
However, in recent days volatility has been rising as investors become more skeptical on the “Trump reflation” trade. The VIX hit 15 last week, the highest level of the year and a 40% increase from the March bottom. Of course, the VIX is still well below its historical average. But should investors continue to recalibrate the likelihood of fiscal stimulus, one of the main drivers of markets since November is likely to ebb.
Should volatility continue to rise, some segments of the market are more vulnerable than others. While so-called “safe haven” bonds and gold are beneficiaries, particularly if growth expectations continue to moderate, there will also be relative winners and losers within equity markets. One of the more vulnerable segments: momentum stocks.
One up, the other down
Momentum stocks, along with the broader equity market, have historically had a negative relationship with volatility. From 1990 to the end of the financial crisis, monthly changes in volatility explained approximately 30% of the monthly variation in momentum returns, with momentum more likely to post negative returns when volatility is rising.
In addition to hurting absolute returns, historically, momentum has tended to underperform less volatile styles, notably quality, during periods of heightened market stress. From 1990 to present, momentum typically outperformed quality during normal market conditions, defined as periods of falling, stable or gently rising volatility. In these periods the MSCI USA Momentum Index outperformed the MSCI USA Quality Index by roughly 30 basis points (bps, or 0.30%) per month. However, during periods of market turbulence, defined as the top quintile of monthly changes in the VIX (corresponding with about a 15% or greater rise in the spot VIX Index), momentum underperformed quality by approximately 40 bps per month.
The relationship between volatility and momentum has actually strengthened in recent years. Since the end of the financial crisis and the advent of the current period of extraordinary monetary accommodation, the relationship has become much stronger. Since the third quarter of 2009, monthly changes in the VIX have explained nearly 50% of the monthly changes in momentum returns. See the chart below.
The lesson for investors
As volatility shifts, pay attention to factor exposures as well as your asset allocation. Momentum had a good run since mid-November. If volatility continues to normalize, that is likely to change.