Most sentient investors are aware of the low volatility that characterizes the current environment, with the S&P 500®’s trailing twelve-month annualized volatility at approximately half its level from a year ago. This trend was driven in part by some significant negative inter-sectoral correlations, for example between information technology and real estate versus financials, and energy versus information technology (see Exhibit 1).
Going a step further at the sector level, we observe decreases in volatility across the majority of sectors. Most notably, energy had the largest decrease (see Exhibit 2).
As illustrated in the most recent sector dashboard, the S&P 500 Energy sector’s trailing twelve-month annualized volatility was 13.2% as of Dec. 29, 2017—approximately half the sector’s 23.6% volatility from the prior year, with volatility declining steadily over the past twelve months. Historically, energy volatility has ranked roughly at the median of all sectors. We witnessed an aberration in recent years, as the sector’s volatility reached peak levels. However, this trend has reverted during the past year.
Market volatility can be understood in terms of two components: dispersion and correlation. Dispersion measures the degree to which index constituents perform differently, and correlation measures the tendency of index constituents to rise or fall at the same time. The decline in energy sector volatility has been driven by declines in both correlation and dispersion.
Exhibit 3 shows that the average trailing twelve month dispersion for the S&P 500 Energy sector was 13.4% as of Dec. 29, 2017, versus 20.5% one year prior. Similarly, the average trailing twelve month correlation for the S&P 500 Energy sector was 0.43, versus 0.57 one year before.
While energy was the second-worst-performing sector in 2017, performance has picked up so far in 2018, with the sector up 5.9% for the month as of Jan. 19, 2018, aided by strengthening oil prices. Will this performance tailwind reverse last year’s decline in volatility? We shall wait and see.