In a new report from BofA’s equity derivatives team, the bank analyzes how vol regimes have existed through time spanning subsequent bull and bear markets, where bull market vol tends to be a good predictor of the following bear market vol (chart below, left-hand side). The bank has found that vol tends to be somewhat predictable within market cycles, and that bull markets in particular exhibit a “volatility smile” in which realized vol is more elevated during the first and fourth quartiles of each period relative to the second and third quartiles (chart below, right-hand side).
Simplified, and rather intuitive, this shows that volatility rises heading into the end of a bull market. Which is ironic because as Nitin Saksena notes, as recently as the end of January and before the Feb vol shock, realized vol was near the most depressed levels in history, suggesting perhaps even more upside pressure as we head into the late stages of this bull market. For perspective, 12m realized vol as of 26-Jan-2018 (the peak of the current cycle) was 7.0%, a level below even the least volatile bull market in history from June-1962 to Feb-1966 when realized vol was only 8.4%.
How quickly things have changed in the past 2 months, when both implied and realized vol has exploded higher.
So what happens next in theory?
To answer that question, BofA first looks at a stylized example, and finds that based on historical data, vol has risen 3/4ths of the time in the last 12 months of a bull market relative to the period prior to the last 12 months. The BofA chart below on the left-hand side plots looks at some of the more popular recent bull markets and plots the SPX realized vol 24 months to 12 months prior to the end of period vs. SPX realized vol during the last 12 months. The chart shows that 9 of the 12 periods (those above the dashed line) saw vol pick up, the biggest being the bull market ended by the start of WW2 (Apr-42 to May-46). In other words, “history suggests that if we are indeed in the final innings of the current bull market, it is more likely than not that we will see upward pressure on realized vol.”
To be sure, rising vol in itself is not a necessary and sufficient condition for a recession, although even if the bear market is 24 months away, vol still tends to rise according to BofA. What’s more, even if the there is some gas left in today’s bull market – a case made by virtually every Wall Street analyst – increasingly more are expecting an uptick in realized vol.
Specifically, we found that vol also tends to increase heading into the final two years of a bull market relative to the year before. The most prominent examples occurred during the Oct-90 to Jul-98 bull market, which saw a large pickup in vol in the last two years amid the start of the Tech Bubble, and the Aug-82 to Aug-87 bull market, which saw vol take off ahead of the Black Monday crash in Oct-87.
Stepping back from the abstract, BofA’s next question is troubling, if only for the bulls, because the bank asks, point blank, “what if Jan-2018 was the peak and we are now at the beginning of a new bear market?”
To answer this, BofA extends the above analysis further to examine how vol reacts during the first 12 months of a subsequent bear market relative to the final 12 months of a bull market. The bank’s results indicate that in 13 of 15 bull-to-bear market rollovers, vol increased. Of course, this result is not exactly surprising as everyone – perhaps with the exception of a 23-year-old “hedge fund manager” – expects bear market vol to surpass bull market vol (after all, full period median bear market vol is 21.0% versus a bull’s 12.9%).
There is one caveat, or rather two: there are two instances in which vol declined at the start of the bear market relative to the end of the prior bull market: Jun-49 to Aug-56 and Oct-74 to Nov-80.
So going back to the original question: was Jan 2018 the peak for the market… something which Morgan Stanley determined last week, and has a new bear market unofficially begun, the first in a decade? Should we get a few more days like today’s Nasdaq collapse, we won’t need complex vol analyses for the answer.
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