From Macrofugue:
With the S&P 500 off 5% from all-time highs, and the 10-day volatility in the 87th percentile, some observers are anticipating a 1987-style market correction. In this piece, we analyze the conditions that presaged prior violent corrections.
Starting with what the most recent level of volatility provides us, we split the sample of 10-day historical annualized volatility readings into 2% buckets, and calculate the median, minimum and maximum 10-day annualized volatility which immediately follows:
We estimated best fit lines using a robust linear fit to exclude outliers. The R code to generate this plot is here.
Although much of the narrative seems to indicate that an elevated level of volatility is a harbinger of higher levels of future volatility, the median case actually shows that future volatility is a fraction (2/3rds in this case) of what was recently experienced, plus a base level (of 3.32). There are outliers, of course, but they are exogenous to the relationship between realized and future volatility. To gain insight into the volatility spikes, we must look elsewhere.
The average annualized volatility out of recession is 13.88%, while it spikes to 17.3% in recession. Volatility has only eclipsed 20% outside of recession (or impending recession) twice — the crash of 1987, and the Eurozone meltdown in 2011. Because recessions are the most common cause of volatility, we measure the probability of that kind of event with our proprietary macro model, and include University of Oregon’s Professor Jeremy Piger’s Recession Probability model for additional signal....MORE
