Financial-market analysts, like their colleagues from other professions, often try to draw conclusions from past behavior for the present and future. At the beginning of an analysis, the question of the appropriate observation period always arises. In addition to one, three and five-year periods, long-term studies often refer to ten-year experiences. There are few obvious reasons to look at ten-year periods, of all things. However, many studies use this timeframe as a reference to estimate the volatility or loss risks of financial assets.
In the coming weeks, ten-year ex-post volatility calculations are likely to have a special surprise in store: September 15 is the tenth anniversary of the bankruptcy of Lehman Brothers. The weeks following the collapse of what was then the fourth largest investment bank in the United States were marked by severe market fluctuations. These days will now successively fall out of the calculations covering a ten-year period. Our "Chart of the Week" simulates the development of ten-year volatility for U.S. equities, based on the S&P 500. If we are spared a repetition of the chaotic market movements of autumn 2008, the ex-post calculated volatility should decline. This trend will be reinforced by recent periods of extremely low volatility, such as 2017. A similar movement was observed in the autumn of 1997, when the crash of 1987 was no longer part of ten-year calculations.
If volatility declines, investors are likely to consider taking bigger positions at a given risk limit and that may include allocating more funds to equities. All other things remaining equal, higher allocations and increased demand would lead to higher valuations. This effect can also be observed in reality: in recent decades, low volatility and thus (at least on paper) low risks correlated with a high price-to-book valuation for the S&P 500, and vice versa. Hence, rosy times ahead in the tenth year of the bull market? Maybe, but the market has adapted to a low-volatility environment, as a closer look at valuations reveals. In this respect, we remain constructive but vigilant.
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 9/12/18