Last year, conversations around volatility permeated the client meetings at Burgundy. During portfolio reviews, discussions often turned to how regularly the equity market indices had been reaching new highs and the very low level of volatility they had exhibited.
There are various measures for market volatility, but one that is often used is the Chicago Board Options Exchange (CBOE) Volatility Index, or VIX.
CBOE describes the Volatility Index as “a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices,” highlighting that, “Since its introduction in 1993, the VIX Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.”1
Unlike the well-known S&P 500 Index, the VIX is not based on the price of a group of stocks. It is a measure of the expected level of fluctuation in the premiums (i.e., price) of the options on the S&P 500 Index over the next 12 months, a measure of expected future volatility.
You can think of options like an insurance policy. Investors use them to protect their portfolios from potential scenarios. Similar to other forms of insurance, the greater the perceived risk, the higher the premiums. When the anticipation of risk causes investors to seek greater protection of their portfolios, the price of options (and the price of the VIX) rises.
The CBOE has compiled valuations for the VIX since 1990. From 1990 until the end of 2016, the VIX’s average annual volatility was 19.2 (the higher the number, the greater the level of expected future volatility). In 2017, the VIX averaged only 11.1, which is lower than any average annual VIX value on record. For comparison, the next lowest year for the VIX was 1995 when it averaged 12.4 and the highest year was 2008 when it averaged 32.7. The steady market increases and low volatility of the past year can be largely attributed to a continuation of easy credit conditions after years of accommodative monetary policy by many of the world’s central banks.
These market circumstances are significant to investment managers like Burgundy. As thoughtful stock pickers, we opportunistically take advantage of volatility to purchase the common stock of high-quality companies when they are undervalued. The opportunities to take advantage of market inefficiency are more limited when volatility is low. For the past couple of years, this environment has made it challenging for us to find businesses that meet our quality screens and trade at attractive values.
The current equity bull market started about nine years ago, back in early 2009. Based on the S&P 500, it’s the second-longest cycle since the October 1990 to March 2000 bull market. As Burgundy clients know, we pay little attention to benchmarks; however, our high-quality investment approach tends to outperform relevant benchmarks in the early to mid-stages of the market cycle and underperform in the later stages (when lower quality, more cyclical, and riskier investments tend to dominate).
Looking back at recent history, we can identify periods when the markets have become overvalued: the tech bubble, which was followed by the tech wreck, and the commodity bubble, which was followed by the financial crisis. During these periods, many of Burgundy’s investment mandates underperformed their benchmarks. However, when the tech and commodity bubbles burst, we recovered our previous underperformance and went on to outperform the benchmarks. If we fast forward to the current cycle with today’s high valuations, many of our investment mandates are again trailing their benchmarks – though absolute returns have been satisfying. Over the past few years, the reasons behind the market’s enthusiasm have often been the same as the ones generating such minimal volatility.
In the current equity market environment, the S&P 500 Index of U.S. stocks peaked on January 26th of this year. The broad-based market correction we have been experiencing has brought the market volatility that we knew would eventually return. So far, over the month of February this year, the VIX has averaged 24.4.
We do not know how long this recent bout of long-delayed volatility will last or when this cycle will end. Despite its long duration, the cycle may continue for a while. The economic data looks robust, interest rates remain low by historic standards, and there is still plenty of liquidity in the capital markets. We welcome the buying opportunities that can come with the return of volatility and, should it persist for an extended period of time, we will be very comfortable with the high-quality companies that make up our clients’ portfolios.
This post is presented for illustrative and discussion purposes only. It is not intended to provide investment advice and does not consider unique objectives, constraints, or financial needs. Under no circumstances does this post suggest that you should time the market in any way or make investment decisions based on the content. Investors are advised that their investments are not guaranteed, their values change frequently, and past performance may not be repeated. The information contained in this post is the opinion of Burgundy Asset Management and/or its employees as of the date of the post and is subject to change without notice.
Article by Mark Gallien, Burgundy Blog