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A Counter-Point on Volatility


But I thought it was different this time?


There has been nearly incessant talk of the low volatility levels lately, and probably for good reason. We are not used to low volatility periods, particularly in the past five or even 10 years.

Most use the VIX as a measure of that volatility. The problem with that is that it is limited in scope. We only have VIX readings back to 1986, and that just doesn't provide us with enough market cycles to gauge whether what we are seeing now is truly unusual or not.

What we can use instead is historical volatility - Bernie had a column about that earlier today. The chart below shows the 22-day historical volatility for the Dow Jones Industrial Average back to 1950 through April of this year (when I last discussed this phenomenon on my site). This is a pretty good substitute for the VIX - although the VIX is supposed to reflect expectations of future volatility, it is primarily derived from traders' experiences with actual volatility experienced in the recent past - the correlation between historical vol and the VIX has consistently hovered around 85%.

What the chart highlights in red are the number of consecutive days the Dow went with its historical volatility remaining under 20, in other words a low-volatility environment (or at least not a high-volatility one). What we see is that about once every decade, we go several years with depressed readings. This has been the pattern for over 100 years.

The current cycle has been 562 days (it shows 491 on the chart), which is definitely more than we're used to, but in fact it's well below the average of the other low-volatility periods in history. Considering that we just emerged from one of the most extended periods of high volatility in history (in the years surrounding 2000), perhaps it's not so unusual that we're seeing what we are now.

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