In our last update, we pointed out the risks in the emerging markets. That theme has continued to play out. By now, investors would’ve experienced maximum losses of -44% in China and -32% in EM equities. US equities is still doing better than other markets – currently at -12% maximum loss.

In this environment, every online robo-advisor is telling their investors to keep calm and carry on. We here at Cassia prefer to be more proactive when it comes to managing risk. We have been performing emergency rebalances in all of our client accounts since August 22. And we continue to monitor the situation in real-time to ensure accounts can move quickly as new data comes in.

Quantifying the risk

The best decisions are data-driven. So what is the data telling us about the current markets? Let’s talk about risk. No I’m not talking about the flawed risk measures that everyone can calculate in Excel. I’m talking about a GARCH volatility forecast that accounts for nuances like clustering and mean reversion that we wrote about in our white paper.

Typically, the S&P 500 has a volatility of 12%. In October 2008, it had a forecasted volatility of 51%. Today, our advanced risk forecasting system sees short-term volatility at 18% and 3-month volatility at 13%[1].

This tells us two things about US Equities.

  • The current level of volatility isn’t crazy high by historical standards.
  • The forecasted volatility in the short-term is higher than the long-term (i.e. backwardation).
  • Volatility spike – what does it mean?

    The second point warrants some investigation. So we ranked the volatility forecasts into four buckets (quartiles). We ask ourselves: “how volatile is the market relative to the long-term volatility?” Do spikes in the short-term volatility have any implications for future returns?

    Lo and behold. During the bull market from 2009 to present, the market appears to yield higher returns after volatility spikes. Q4 represents the days where the volatility is the highest, and Q1 represents volatility being the lowest, relative to forecasted long-term volatility.

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