When the Dust Flies: How Volatility Events Affect Asset Class Performance

Abstract

Some investors have been surprised by the duration of the current stock market rally and, until just recently, the very low level of equity market volatility (e.g., VIX). However, many are concerned about the possibility of market volatility spikes. We investigate asset class performance before, during, and after volatility events. Specifically, how do stocks and bonds perform during such events? Is asset class performance leading into an event different than after the event? We first define two types of volatility events: “spikes” and “post peaks”. A volatility spike event is a significant sudden increase in volatility, and we measure asset class performance while “the dust is flying.” In contrast, a volatility post peak event is a period of high volatility that is followed by volatility returning to its pre-peak level, and we measure asset class performance “after the dust has settled.” While both types of events are of interest to investors, some investors may act at the onset of a volatility event (i.e., a spike), whereas others may wait until market volatility has calmed down (i.e., after the peak). We examine 26 volatility spike events, and 25 post peak events, across a 68-year span, in a variety of market environments. History shows that while spike events produce large negative returns for equities and credit bonds (with positive returns for Treasuries), markets recover relatively quickly, approximately by the seventh month following the spike month. For post peak events, we focus attention on asset class performance after the dust has settled, not around the peak volatility event itself. The increase in volatility and accompanying equity and credit market declines may be unnerving to some investment committees. These investors may wish to wait until the “dust settles” – either out of caution or time needed for deliberation – before re-examining their investment strategy. History shows that once the dust has settled, equity and credit markets tend to perform well, often better than before the volatility event. The evidence from both types of volatility events suggests that the damage from volatility events is transitory and is likely to be repaired after a reasonable period. These results provide support for investment committees who intend to “stay the course,” and possibly re-balance with increased allocations to risky assets.