Risk-return relationship is a force of nature

From its record heights of January 2022, the benchmark S&P 500 index has fallen into bear market territory — down 20% from its recent peak. As usual, the market has not gone quietly into the night. It has lurched across the street — mostly in a southerly direction

— in a series of wide daily moves, more down than up from day to day.

The market has not only declined, it has become decidedly riskier, more volatile. The difficulty of predicting its value has dramatically raised the cost of insuring against such market risks. The volatility index, the VIX, which reflects the cost of an option to buy or sell the S&P at current values, has almost doubled, rising from a below-average 16.6 in early January when the S&P index stood at 4,796, to 31.4 on June 21, with the index at 3,764 — down 24%.

The average daily value of the VIX since 2000 has had a strongly mean-reverting character, with a long-term average of 19. Encouragingly so for those hoping for a return to something like normal risk aversion. It is clear that an increasingly risky environment has led, rather than been followed by, the share and bond markets.

The negative relationship between changes in share market risk, as measured by daily moves in the VIX and daily changes in the S&P index, is statistically significant. The simple correlation has been close to a one to one (R= -0.85) in 2022. Trading the VIX or the market in 2022 will have given highly equivalent results.

Taking on more risk demands greater expected return, which is then assisted by lower market valuations. Hence when risks are up, share and bond prices are likely to have declined to improve expected returns.

The volatility of the usually less risky market in US treasuries has also increased dramatically, and bond values have declined sharply in 2022. Long-term US bond yields have more than doubled in 2022 and bond values have declined in similar proportion.

Bond market volatility is calculated off option prices on bonds in an index known as the Move. The Move index has risen from 83 to 139 this year. Its long-term average is about 80.

The origin of these highly elevated market risks is clear. It is that the Federal Reserve and other central banks will go from bad (allowing too much inflation) to worse — a recession that could follow aggressive interest rate increases and a consequently over-sharp reduction in spending. This danger has been intensified by the post-Covid shortages of labour in sectors of the economy most devastated by the lockdowns that are now recovering strongly. The “wanted” signs for waiters and airport bag handlers in developed markets will not be coming down soon, and the unemployment rate in the US is likely to remain exceptionally low. A full-employment recession is not in the Fed playbook, but it should be in these unusual times of extraordinary stimulus followed by inflation that could ultimately prove to be transitory should the right policies be adopted.

The optimists in global equity markets must hope that the perceived dangers of Fed errors decline. If so, daily volatility will decline and share prices will trend higher.

The relationship between risk and return is easily ignored after the event when the risks assumed turned out to have been overestimated. When returns are measured and have exceeded the returns provided by an objectively better diversified and less risky portfolio, the fee-charging, risk-conscious investment adviser is unlikely to be appreciated.

However, managing risks is as important as searching for returns. You never know for certain what will happen in advance, and risk avoidance can be extremely valuable. Risks taken to achieve the returns realised should be well recognised when evaluating performance — as should market risks given that some markets are riskier than others.