Why Stock Volatility Could Surge

The first half of 2018 is over, meaning we are entering the third quarter, which historically has been the worst quarter of the year. You can see in the tables below it's the only quarter averaging a loss over the past 20 and 50 years. On the bright side, five of the past six third quarters have been positive.

These results are very general, looking at all years over those time frames. Next, I’ll look at the unique price action over the first half of this year and find comparable times for stocks to see how it panned out over the course of the rest of the year.

SPX Positive In 1H Despite 10% Pullback

The S&P 500 Index (SPX) fell more than 10% on a closing basis from late January through the first couple weeks of February. Despite that drop, however, the index was slightly positive in the first half of the year. Going back to 1929 (as far back as we have S&P 500 data), there have been just 10 other years in which the index suffered a 10% pullback but was still positive at the year’s midpoint. The second half of those years tended to outperform other years at the expense of higher-than-normal volatility, as measured by the standard deviation of returns.

July tended to perform especially well in those years, averaging a 2.62% gain with 70% of the returns positive. In other years since 1933 (the year of the first signal), July has averaged a gain of less than 1% with 55% of the returns positive. The next six months averaged a 9.70% gain, compared to a 3.55% gain in other years.

Here is a list of those years I mentioned above. The last instance was 2009, which was the culmination of the financial crisis and the beginning of the current long-term market rally. The time before that was 2003, which also marked a major bottom and the beginning of a long-term rally. This time is markedly different than those two occurrences.

Years Similar to 2018

I occasionally use a least-squares method to find similar chart patterns. Doing this with the first half of 2018 (using the S&P 500), I found the three years in the chart below that have the most similar chart patterns so far. Specifically, 1952 and 2004 saw significant volatility in the second half of the year, but ultimately gained over 6% in the second half. Meanwhile, 1993 saw less volatility than those years but the index saw a smaller gain of about 3.5%.

If I look at the 10 years most similar for the S&P 500, I get the data below. The earliest year is 1944, so I looked at returns since then for comparison. Typically, July has been strong, but stocks tend to struggle in August and September. The similar years mimic that, with July being weaker than normal. Looking at the next six months shows an average 5% return, which isn’t too far off the typical return of 4.30%. The consistency of positive returns, though, has been impressive, with nine positive years in the 10 most analogous years.