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Beware volatility ahead? FTSE100 could fall between 20-25%, warns new study

  • FTSE100 has returned an annualised -22% in periods of high market volatility
  • FTSE100 underperforms US equities when markets turn volatile
  • Recognising when markets move into periods of high volatility is one way to deliver outperformance

 

With investor fears rising that markets are currently stretched, a new study by Collidr warns that UK equities underperform US equities during periods of high market volatility.

Collidr’s study shows that in periods of high market volatility since 2005, the FTSE100 has underperformed US equity indices, returning an annualised -22% in comparison with the S&P500 which returned an annualised -19%. Perhaps surprisingly, the FTSE100 even underperformed the Nasdaq composite, which returned an annualised -14% in high-volatility periods.

The FTSE All-Share index has performed even more poorly during high-volatility periods, returning an annualised -23%. The study also shows that emerging markets equities have fared the worst among all major equity asset classes during periods of high market volatility, with the MSCI Emerging Markets index returning an annualised -31%.

All markets exhibit volatility. According to Collidr’s proprietary methodology, volatility generally falls into three categories or ‘regimes’ – low, medium and high. Collidr is able to analyse and report on these periods distinctly, delivering valuable insights.

In Collidr’s study, which calculates the performance returns of various assets for these specific time periods (or regimes) since 2005, it shows the importance of investors identifying and preparing their portfolios for periods of elevated market volatility, by rebalancing towards asset classes that outperform in these periods.

Investors who can spot impending periods of sustained high market volatility are better able to limit their losses and build wealth more quickly than those who simply ‘buy and hold’ and do not change their portfolios.

When markets have been in a high volatility period, Collidr’s study shows gold has performed the best of any asset class, delivering an annualised return of 12% since 2005. Other asset classes that have delivered strong positive returns in high volatility periods include government bonds and safe-haven currencies, with US Treasuries having returned an annualised rate of 10%, and the US Dollar index returned an annualised 7%.

How to structure a portfolio for periods of high volatility

Collidr says that when investors have been alerted to impending market volatility, they are then able to prepare their portfolios to not just defend against the risk of a market correction but also benefit possibly, depending on the assets they use, or trading strategies implemented.

The study shows that in markets with low volatility, the tech-heavy Nasdaq composite has outperformed the other main stock market indices by a distance, delivering an annualised return of 16% in low-volatility markets since 2005. This is followed by the S&P500 with a 13% annualised return in low volatility periods, and the MSCI Emerging Markets index with a 10% annualised return.

The only major asset class that performs negatively in low volatility is the US Dollar index, which has returned an annualised -1% in low volatility markets since 2005.

How to spot impending volatility

Collidr says that tracking unusual or outlying market behaviours is key to spotting impending volatility. A simple example is when bonds and stocks  go down together, breaking their established anti-correlated relationship during periods of low volatility.

Outlier market behaviour – red dot represents S&P500 and Treasuries falling on the same day, blue ellipse represents normal behaviour in a low volatility market

Collidr says that increased market volatility often occurs in clusters, with a day of high volatility in the market usually being followed by another day of high volatility. This can continue for periods ranging from a month, i.e. ahead of national lockdowns at the start of the pandemic, to over two years, such as during the global financial crisis.

These periods of high market volatility ultimately lead to unexpectedly extreme returns. However, volatility does settle down eventually and oftenreverts back to its average level over the long-term.

Positive and negative high volatility occurs in clusters – dots reflect S&P500 returns on individual days

Symon Stickney, CEO of Collidr, says: “Recognising the signs of volatility is possible for investors. Those who can use that information to make good decisions about their portfolio construction increase their probability of success and build wealth more effectively in the long term.”

“Instead of trying to forecast returns – which at best is educated guesswork – more investors should be focused on identifying the markets’ volatility and adapting their portfolios to match.”

“Volatility is not always a harbinger of negative returns. Increased volatility can also be positive – it can be an opportunity for investors to generate significant outperformance if their portfolios are constructed in the right way.”

“While technology stocks have outperformed most other equity sectors during periods of high volatility since 2005, investors should be wary about whether that will continue to hold true. If the next period of high volatility coincides with interest rate rises, their valuations could be impacted.”

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