Volatility Warning Signs

Since the end of the federal reserve's latest QE program, market volatility has picked up markedly. Since October, as QE came to its final bond buying conclusion, the drain of liquidity begin to financial market activity. As shown in the chart below, there have been three fairly sizable selloffs last quarter of 7.9%, 5.0%, and 4.3%.

Not surprisingly, those selloffs gave birth to sharp spikes in volatility of 118%, 99% and 46.9% currently.

Since the beginning of QE-3, at the end of 2012, the financial markets have been on a seemingly unstoppable rise. While virtually 100% of all economists, analysts, and financial bloggers are currently expecting a continuous rise in asset prices for several more years, the one constant has been a steady decline in volatility. The lack of “fear” in the financial markets has been the “sirens song” for investors to step up to the casino table and place their bets in a seemingly “can't lose” bet. Each dip has now taught investors that such moments are fleeting, and those declines are best ignored. That is a dangerous lesson, to say the least, as things may now be changing.

The chart below shows a 6-month average of the volatility index. By smoothing the index, we can get a clearer picture of the trend of volatility over time. As shown, the trend of volatility has been in a steady decline since the beginning of 2013 but is now showing signs of making the first turn higher since the 2011 debt-ceiling debate market rout.

As shown by the red arrows, historically the turns higher in the smoothed volatility index have either occurred near major market peaks or during major bear markets. While it is clear that we are currently NOT in a major bear market as of yet, the turn higher in volatility is a clear warning sign that the six-year bull market in equities, one of the longest uninterrupted runs in history, may be nearing its end.