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At the Mountains of Volatility

The third quarter of 2022 carried historically high volatility, with daily returns on the S&P/TSX posting an annualized standard deviation of more than 16%.

Price volatility is all about uncertainty and right now there is no shortage, as debates swirl over:

  • The path of inflation and the end game for Fed rate hikes;
  • Demand for long-term bonds and their ultimate yields, which set the base rates for valuing all asset classes;
  • The strength of the consumer faced with higher prices and interest rates; and
  • The direction of corporate earnings heading into 2023.

Our outlook on these points has not changed a great deal since the beginning of the year:

  • We believe the Federal Reserve and the Bank of Canada when they say they will do everything in their power to tame inflation.
  • We don’t expect prices to tame themselves – inflation doesn’t slow without the economy slowing.
  • We expect government bond yields across all expiries to rise through year end, which will put an end to TINA thinking and present significant competition for equity flows.
  • We suspect the consumer is not as strong as their recent spending suggests.  The laws of gravity on spending and credit growth should reassert themselves.

As markets reset to a world of higher rates, we expect companies to feel the pinch from these factors sooner, rather than later.  The worst hit will be those companies with high multiples and low, or non-existent, earnings.

Beyond these pressures and uncertainties, there is also considerable information to be had from looking at volatility itself.  There are a few things we know about past periods of high volatility:

  • High volatility quarters follow high volatility quarters:  Volatility is strongly correlated.  Over the last 25 years, when quarterly volatility has been 15% or higher, the next quarter has seen volatility of 15% or higher about two thirds of the time, with next quarter volatility averaging 20%.
  • Higher volatility is associated with weaker returns: Looking back on the last 25 years of S&P/TSX returns, when average quarterly volatility has been 10% or lower, quarterly returns have averaged 4.8%.  At 10% to 15% volatility, returns have averaged 4.1%.  At 15% to 20% vol, returns have averaged 0%, and for quarters with volatility above 20%, returns have averaged negative 5.5%.
  • Negative returns are more likely in higher volatility periods: Since 1997, when quarterly volatility has been above 15%, the probability of a negative quarterly return has been roughly 58%.

Given that the sources of uncertainty we have highlighted are unlikely to fully resolve themselves in the short term, we expect volatility to remain elevated in the fourth quarter, which more likely than not means choppy markets and disappointing returns.

As always, we think the best antidote for uncertainty is sticking to high quality companies with strong free cash flows, clean balance sheets and capable management teams.  We continue to benefit from the ideas generated by our affiliate Veritas Investment Research Corporation, which remains one of the best research shops on the street.

Year-to-date through September 30, 2022, the NASDAQ was down 32.0%, the S&P 500 was down 23.9% and the S&P/TSX was down 11.1%.  Over the same period, our Canadian Equity Fund fell 7.8% and our Absolute Return Fund was 9.3% lower.  (Performance based on F series).

We remain focused on capital preservation during the current market volatility while pursuing opportunistic investments to drive returns.

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