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Volatility is reverting to its long-term average: Key implications

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What does this recent bout of volatility tell us about the economy and financial markets?

Volatility is returning to its long-term average. First, to a large extent, the recent rise in volatility points to a return to a more typical market environment. While imperfect, the VIX Index, a popular measure of the implied volatility of S&P 500 index options, provides a good illustration of this phenomenon.

Between 1990 and the end of 2011, the VIX Index averaged roughly 20%. Since the start of 2012, the VIX Index has hovered around 15%, and during the first eight months of this year, the average fell to a little over 13%. More or less, volatility has recently simply reverted to its long-term average.

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Market Realist – The recent surge in volatility has spooked investors. But the recent surge shows a reversion of volatility to its long-term average, as you can see in the graph above. The average VIX index between 1999 and 2013 was 20.2. Volatility has been below the long-term average for most of 2014 despite the increasing geopolitical turmoil.

Both the U.S. equity market (SPY)(IVV) and global markets (QWLD) have experienced a period of tranquility due to the Fed’s accommodative monetary policy. With the bond buying (TLT) program likely to end this month, market volatility (VXX) is back on the horizon, and it looks like it’s here to stay.

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Market Realist – The graph above shows the CBOE SKEW index. The SKEW index is much like the VIX but it measures the fear of a “black swan event” (or crisis of unexpected magnitude) among investors. As per CBOE, the index values are calculated from weighted strips of out-of-money S&P 500 (SPY) options. If there were no expectations for a “black swan” event, SKEW would be close to 100.

The index rises as the expected risk increases. The SKEW index has remained above its long-term average of 117.2 for the majority of 2014. Eight out of SKEW’s 12 highest closing days from 1990 onwards have occurred in 2014.

Volatility seems to be back after a period of calm, and it looks like it will extend to next year.

Read on to the next part of this series to see why the increase in volatility is consistent with past cycles.

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