Where is the Volatility?

English language has popular phrase: “As volatile as the stock market”. If history offers any evidence, stock markets are most volatile asset class but, since April last year, markets have seen very little of it. Global markets have been stable. Volatility Index in India, India VIX, a measure of volatility in the country has been trading between 12- 18 for the past one year. To put things in a perspective, when COVID first started striking us in early 2020, India VIX traded at 60. Such was the perceived uncertainty in the markets. But why does it seem to trade at sub 20 levels and what explains the stability? Is it the calmness that is usually evident before the storm? Should investors be prepared for a roller-coaster ride?

There are similarities in the current bull run, which has taken Nifty from sub 8,000 levels in March 2020 to above 17,000 in September 2021, and the one seen in 2003-2007. The previous bull run took Sensex from 3,000 in 2003 to 20,000 in 2007. From 2006 to 2020, markets have corrected by over 10% on more than a dozen occasions; This means, on an average, one correction of above 10 % per year. Such corrections are typical in the financial markets.

The current bull run will have its share of sharp corrections but, at what time, it is difficult to say. Some probalistic assertions can be made.

Markets are heavily over bought and cannot accelerate in one way only. So, what can we say about the likely triggers of a correction?
Some cues can be read from the investment decisions made by foreign portfolio investors (FPIs). FPIs have been net sellers since July 2021 and seem sceptical about market valuations. Retails investors account for 45% of turnover whereas FPIs account for only 11% in the market but FPIs hold a little over 27% of the Indian stocks. Retail investors and DIIs together hold less than 16% of the Indian stocks. Previous bull run (2003-8) tells us that the exuberance and domination of retail investors can switch sides.

FPIs will become big sellers when the negative mood grips the markets. The negative mood may emerge when a big shift of capital from equity to bonds happens. That will surely happen when Federal Reserve bank announces tapering by end of 2021 or when inflation in the US spikes sharply, forcing the bond yields to go up.

When FPIs become sellers there could be a sell-out frenzy in the markets with retail investors not knowing which way to go during corrections and eventually will sell and run. This is exactly what happened in 2000 and in 2008. Mutual fund redemptions will also be triggered, adding to the distress.

This is one way of looking at things. What will actually trigger a correction, we do not know. Whatever triggers the correction, retail investors should be prepared for it. One way is to stick to good quality large-caps and follow a balanced approach by diversifying into other asset classes. Is this a better way to deal with investments during the low India VIX movements? Only time will tell.