Prisma Insight

This brief note provides an analysis of Prisma's risk indicators over recent months.

A quick reminder: ERIC represents the average of all Prisma's risk indicators.

Anticipate market volatility

Since mid-March 2023, Prisma's risk indicators have consistently shown lower risk levels, with the Equity Risk Indicator (ERIC) consistently below 40%. Thus, the Prisma indicators have signaled a "risk-on" sentiment, expecting a favorable environment without major drawdown or spike in volatility. This prediction has held true as evidenced by the S&P 500's gain of over 10% since mid-March and with September 21 marking the first day of a decline exceeding 1.5% in 102 days.

However, the recent period of extremely low risk levels, starting from the end of August, may raise some questions, especially given the slight dip in the S&P 500 since then. In this context, it's essential to remember that Prisma's risk indicators primarily serve the purpose of assessing the inherent market risk, that is, to anticipate the magnitude of upcoming fluctuations — a phenomenon that historically correlates well with crises and drawdowns. In other words, the focus is on predicting volatility, not returns. Analyzing short-term volatilities since the end of August, it's evident that despite the decline in the market, volatility remained remarkably muted. Consequently, even during the recent period of extremely low risk levels, Prisma's risk indicators have proven to be accurate.

To delve deeper into the effectiveness of Prisma's indicators, let's examine the S&P 500's implied and realized volatilities, Prisma's ERIC, and the trajectory of the S&P 500 index. This illustration will provide further insights into the predictive power and reliability of Prisma's risk indicators in navigating the financial market.

The chart shows two clear timeframes in the last year.

• The first period extends up to March 2023. During this interval, the ERIC indicator displayed values exceeding 50%, forecasting high volatilities. This anticipation proved to be pertinent, as both the VIX 1-day (quantifying the market's one-day implied volatility) and the one-month realized volatility of the S&P 500 index were elevated (surpassing 20 and up to 50). It is noticeable that the market returns during this period were essentially flat despite substantial fluctuations.

• The second period unfolds from mid-March 2023, when the ERIC indicator dipped below 40% and remained there. These low indicator values suggest that Prisma risk indicators do not forecast any imminent major fluctuation. This assertion was validated, as during this phase, both implied and realized volatilities consistently maintained values well below 20. In tandem with this trend, the market itself yielded positive returns.

Based on this brief examination, we can conclude that the ERIC indicator has adeptly categorized volatility regimes and accurately anticipated the transition between these two regimes. This performance underscores its reliability as a valuable risk indicator. Additionally, recognizing these volatility regimes may offer insights into predicting medium-term market returns (although this correlation isn't always guaranteed).

Disclaimer: This paper is a simple description of practical use. We encourage you to discover and test our indicators on our platform Prisma. To receive Prisma Insights directly via email click on the following link.

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