The Dynamics of Stock Market Cycles

Above we can see that the volatility of stocks across market sectors has come down significantly since the February lows.  Since 2012, when realized sector volatility has been in its lowest quartile, the next 20 days in SPY have averaged a loss of -.40%.  When sector volatility has been in its highest quartile, the next 20 days in SPY have averaged a gain of +3.54%.  

During historical investigations, I consistently find that intermediate-term returns are significantly tied to volatility and correlation regimes, particularly when the statistical overlaps among realized volatility, implied volatility, and correlation are eliminated.

The reason for this is that the psychological dynamics of market tops differ from those of market bottoms.  Stocks make tops when values become sufficiently stretched to the upside that buying interest dries up.  In that context, the weakest sectors begin to fall off, breadth wanes, correlations go from lower to higher, and volatility shifts from lower to higher.

Stocks make bottoms when values become sufficiently stretched to the downside that the buying interest of value participants is aroused.  This creates a reversal while volatility and correlation are still high, as breadth rebounds strongly.

This interplay of the dynamics of tops and bottoms is what creates market cycles.  Ultimately it is the interplay of shorter-term, momentum/trend players and longer-term value participants that creates the drying up at tops and sharp rebounds at bottoms.  Tracking volatility and correlation regimes is a way of gauging, in relative terms, where we stand in intermediate-term market cycles.

Further Reading:  Sector Correlations
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