Bumpy, not Bearish

Key points:

• Sharemarket volatility is on the rise.
• Volatility is likely to remain high reflecting economic uncertainty associated with inflation worries, rising global interest rates and slowing US/global growth.
• But while the ride may be rough for a few months to come, this is unlikely to signal the start of a major bear market in shares.

After three relatively calm years it seems share market volatility has returned. The first chart shows one measure of volatility: the number of days in which sharemarkets rose or fell by 1% or more over rolling periods of 40 trading days (two months). This is shown for both Australian shares and an average of the US, Japanese and European sharemarkets. Over the past 40 trading days, Australian shares have seen 16 days in which the market moved by 1% or more, whereas between 2003 and most of last year this was running below five days in every 40 days. Similarly there has been a sharp spike in the number of days in which global shares moved by 1% or more.

Other measures of volatility have also risen, including the US VIX index of implied equity option volatility, which spiked higher over the past two months, as well as conventional measures of volatility such as the standard deviation of monthly sharemarket returns.

The volatility cycle

The first thing to note is that low levels of volatility over the past few years were not particularly unusual in a long-term historical context. This is clear in the second chart.

While progressively less volatile economic cycles suggest that sharemarket volatility should have trended down over the past century, there is little evidence of this occurring. As the second chart shows, volatility measures for the Australian and US sharemarkets have, apart from aberrations around the Great Depression and World War II, and around the high-inflation 1970s, essentially been locked in a relatively narrow range for the past 100 years or so.

The lack of any clear long-term decline in sharemarket volatility over the past century may reflect several considerations including little long-term decline in the volatility of corporate profits, higher levels of gearing leaving investors and companies more vulnerable to any surprises, more correlated bets by investors (more investors having similar positions and changing those positions at the same time), shorter holding periods for shares and a greater focus on momentum trading.

But the second chart indicates there is a cycle in the level of sharemarket volatility. Volatility is driven by a combination of new information that surprises the market and the market’s level of vulnerability to that surprise. For example, if investors are fully laden with shares, any surprisingly bad news could result in sharp falls. However, if they only have modest exposures then there would likely be less selling pressure.

The short-term cycle in volatility largely reflects the economic and investment cycle:

• Volatility tends to rise during the boom, bust and then initial recovery phases in the business cycle. This tends to be when economic surprises '” both good and bad '” are at their greatest and is often magnified in terms of their impact by high levels of corporate debt, sharemarket over-or under-valuation and extreme high or low exposures to shares by investors. Hence this is when investors and therefore sharemarkets are most vulnerable to bad or good news. This explains why sharemarket volatility was generally high between 1998 and 2003.

• Volatility tends to fall and stay low during the mid-cycle phase of the business cycle because this is when the economy is most stable and predictable. This is usually when economic growth is ticking along nicely, inflation is benign, interest rates are low, corporate debt is low, shares are not at extreme valuations and investor positioning is not extreme.

In the period between 2003 and 2005, we were in the mid-cycle phase in terms of global economic growth, which explains why volatility was relatively low. Over this period economic growth was generally reasonable, inflation and interest rates were benign and sharemarkets were not over-valued. Although there was bad news on oil prices this was offset by good news on corporate profits. Further, investors generally did not have extreme positions in terms of their sharemarket exposures.

So where to now for volatility?

In a note earlier this year, our assessment was that sharemarket volatility would likely increase such that investors should anticipate a correction of about 15% in Australian and global shares during the course of the year, but within the context of a still rising trend. There is no reason to change this overall assessment. There are several reasons to expect volatility to be high over the months ahead:

• We have moved well beyond the “sweet spot” in the US/global economic cycle into the boom/slowdown phase. The major regions in the global economy led by the US are now moving around the top of the global economic cycle, which is normally associated with increased levels of volatility.

Inflation risks have increased, interest rates are rising in most regions and becoming restrictive in the US, profit growth is slowing and there is uncertainty as to whether the US economy '” and to a lesser extent the Chinese economy '” will have a soft or hard landing. It is very difficult to determine where to place the Australian economy in terms of a stylised economic cycle because it has not had a clear cyclical profile for many years. However, it is clear that rising cost pressures, inflation risks and rising interest rates mean Australia has entered a more volatile phase in its investment cycle. In any case, it is readily apparent that the US cycle has been having its normal directional impact on the local share market in recent years.

• Typical for this point in the cycle, corporate borrowing is now rising in the US and Australia and this will eventually lead to greater earnings volatility.

• Corporate profit growth is slowing and actual earnings results are less likely to surprise on the upside to the same degree as in the past.

• Finally, investors’ exposures to shares have increased over the last three years and this has made them more vulnerable to any bad news.

Consistent with this, it is interesting to observe the increased severity of sharemarket corrections over the past few years. In 2004, for example, the sharpest correction in Australian shares was about 3.5% top to bottom, while last year we had two corrections of 8% each and so far this year the market has had a top-to-bottom fall of 12% between mid-May and mid-June. It’s obviously getting rougher out there!

And now for the good news

The good news is that a big increase in macro-economic volatility (ie, surprise) is unlikely '” inflation remains relatively benign and interest rate increases around the world remain moderate. Similarly, investors never became overly complacent: equity valuations have not been pushed to overvalued extremes, but remain at reasonable levels. Vulnerability to bad news is significantly below the levels reached prior to the 2000–03 global bear market in shares. So we don’t expect a severe and sustained increase in volatility as would be associated with a major bear market in shares.

The most likely scenario is that, in the absence of any impending recession or overly aggressive rise in interest rates or some other external shock, sharemarket volatility will remain high for a while. But because valuations and earnings growth are still reasonable, sharemarket returns are likely to remain solid on a six to 12 month view. Although shares are currently recovering somewhat from their May–June correction, we remain of the view that another bout of weakness is likely into the normally weak September–October period, probably driven by worries about the extent of the global growth slowdown not helped by ever higher oil prices.

In this context we remain of the view investors should anticipate a total correction of about 15% in global and Australian shares from their May highs to September–October lows. Once it becomes clear, though, that global growth is slowing but not collapsing, profit growth remains reasonable and that the Fed is getting closer to interest rate cuts, we expect sharemarkets to resume their upswing with a sharp rebound into year end.

Conclusion

Uncertainty about global inflation, interest rates and growth, rising corporate borrowing, slowing profit growth and higher investor exposure to shares suggest sharemarket volatility will remain high for a while. But, we don’t think this spells the start of a major bear market in shares.