WHEN THE DUST FLIES…How Volatility Events Affect Asset Class PerformanceMarch 2020

Institutional Advisory & Solutions

Confidential - Not for Further DistributionFor Professional and Institutional Investor use only. Your capital is at risk and the value of investments can go down as well as up.

Bruce D. Phelps, CFAbruce.phelps@pgim.com

+1 973 367 6661

Junying Shen junying.shen@pgim.com

+1 973 367 8198

March 2020

Introduction§ Back in October 2017…

Some investors are surprised by the duration of current stock market rally and, until just recently, the low level of US equity market volatility:

§ We examine historical equity market volatility events to help investment committees prepare for a future volatility event

§ We examine 27 volatility spike events, and 26 post peak events, since 1950 (a 70-year span), across a variety of market environments

§ Our findings support investors who intend to “stay the course” following a volatility event and possibly rebalance to increase allocation to risky assets

“I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked,” Thaler said. “Nothing seems to spook the market… We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.”

– Dr. Richard Thaler, recipient of the 2017 Nobel Memorial Prize in Economics1

2

1. Nobel Economist Says He's Nervous about Stock Market," Jeanna Smialek Bloomberg, 10 October 2017.

March 2020

Two Types of Volatility Events – Post Peak Events“Post Peak Event”

§ A VIX peak that precedes a significant decline in volatility

§ A decline of ⅓ or greater from a VIX peak over 9m, from month t0 to t0+9

§ Reflects a desire to wait until the “dust has settled”

Schematic of Post Peak Event

Source: PGIM IAS. For illustrative purposes only.

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March 2020

Two Types of Volatility Events – Spike Events “Spike Event”

§ A significant, sudden increase in the VIX

§ At least a 50% increase in the average VIX over 2m, from month t0-2 to t0

§ Reflects a desire to take action in reaction to the sudden change in volatility

Schematic of Volatility Spike Event

Source: PGIM IAS. For illustrative purposes only.

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March 2020

Monthly Volatility Time Series and Spike Events since 1950Spike Event Months

Note: VIX of March 2020 is the average of daily VIX during March 2020 as of Mar 23, 2020. The vertical line is the month in which our volatility time series switches from using DJI price returns to using the option volatility-based, VIX time series from the CBOE.1 The dots correspond to spike months (t0). Source: CBOE, Global Financial Data, PGIM IAS.

§ 27 Spike Events§ About one VIX Spike Event about every three years§ VIX Spike Event examples: 1987 Black Monday; 2008 GFC; 2020 COVID-19

0

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70

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Inde

x

VIX(t0) � 1.5 × VIX(t0-2)Global Financial

Crisis

European Sovereign Crisis

Black Monday

Russian / EM Financial CrisisVietnam Crisis/

Kent StateCuba Missile Crisis / Flash Crash of 1962

COVID-19

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March 2020

§ On average, during a Spike Event the equity market has poor performance (cumulative 2m spike period S&P 500 loss of -7.2%)

§ But, recovers rather quickly, returning to its pre-spike level 7m after the spike month

Spike Events: Market Performance – Equity

Cumulative Monthly Returns – Pre- & Post-Spike Periods

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

-23 -20 -17 -14 -11 -8 -5 -2 1 4 7 10 13 16 19

Aver

age

Cum

ulat

ive

Mon

thly

Ret

urn

(inde

x =

1)

Month

SPX (16 Events; Since 1970)DJI (16 Events; Since 1970)DJI (27 Events; Since 1950)

pre-spike period post-spike period

spike event period

Source: Barclays POINT, Datastream, FRB St. Louis (FRED), Global Financial Data, PGIM IAS.

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Past performance is not a guarantee or a reliable indicator of future results.

March 2020

§ 10y US Treasury has positive total returns (2.0%) during the 2m spike period§ US high yield (HY) and investment grade (IG) credit exhibit cumulative 2m spike period

excess returns of -8.1% and -3.0%, respectively, but both recover approximately 9m after the spike month

Spike Events: Market Performance – Fixed Income

0.8

0.9

1.0

1.1

1.2

1.3

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-23 -20 -17 -14 -11 -8 -5 -2 1 4 7 10 13 16 19

Aver

age

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ulat

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thly

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urn

(inde

x =

1)

Month

10y Tsy (26 Events; Since 1953)10y Tsy (10 Events; Since 1988)HY ExRet (10 Events; Since 1988)IG ExRet (10 Events; Since 1988)

pre-spike period

spike event period

post-spike period

Cumulative Monthly Returns – Pre- & Post-Spike Periods

Source: Barclays POINT, Datastream, FRB St. Louis (FRED), Global Financial Data, PGIM IAS. Past performance is not a guarantee or indicator of future results.

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March 2020

Spike Events: What Happens to Returns?

Total Cumulative Returns

Spike Events

Pre-Spike(21 months)

Spike Period(2 months)

Post-Spike(21 months)

S&P 500 (1970) 20.8% -7.2% 24.9%

DJI (1950) 23.1% -5.6% 24.2%

10y Tsy (1953) 9.0% 2.0% 9.9%

HY ExRet (1988) 3.0% -8.1% 14.1%

IG ExRet (1988) 1.1% -3.0% 4.0%

Source: Barclays POINT, Datastream, Global Financial Data. PGIM IAS. Past performance is not a guarantee or indicator of future results.

§ US Stocks (S&P 500) had stronger performance following Spike Events§ US Treasuries have similar performance before and after Spike Events§ Investment Grade (IG) and High Yield (HY) credit excess returns are very strong in

the post-spike period

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March 2020

Volatilities

Spike Events

Pre-Spike(21 months)

Post-Spike(21 months)

S&P 500 (1970) 13.1% 15.7%

DJI (1950) 12.4% 13.8%

10y Tsy (1953) 5.2% 6.1%

HY ExR (1988) 8.1% 10.7%

IG ExR (1988) 2.7% 4.1%

Source: Barclays POINT, Datastream, Global Financial Data. PGIM IAS.

§ All asset classes are more volatile in post-spike period compared to pre-spike period§ For example, S&P 500 index monthly total return volatility was 13.1% in the pre-spike

period, rising to 15.7% in the post-spike period

SPX

DJI

10y UST

HY ExRet

IG ExRet

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

Post

-Spi

ke P

erio

d Vo

latil

ity

Pre-Spike Period Volatility

45º

Spike Events: What Happens to Volatility?

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March 2020

Spike Events: Equity Sector “Winners” and “Losers”§ By construction, “winners” and “losers” exhibit divergent performance before Spike

Events§ After Spike Events, much of the relative return momentum the “winners” had over the

“losers” is lost, and the performance of “winners” and “losers” converges

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age

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thly

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urn

(inde

x =

1)

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Winners

Losers

SPX Composite

pre-spike period

spike event period

post-spike period

Source: Datastream, PGIM IAS. Past performance is not a

guarantee or indicator of future results.

Pre-Spike Post-Spike“Winners” 46.0% 26.4%

“Losers” -17.4% 15.7%

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March 2020

§ On average, equity market displayed similar 21m cumulative performance before and after spikes

§ Average S&P 500 cumulative monthly total return at the end of the pre-spike period was 20.8%, and a bit higher, at 24.9%, in the post-spike period

§ August 2007 was the only spike event that had a significant negative return in the post-spike period – its post-spike period included the 2008 financial crisis

Individual Spike Event Equity Market Performance

Cumulative Equity Market Monthly Returns – Pre- & Post- Spike Events

8/2007

10/2008Average

0.4

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0.8

1

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-23 -20 -17 -14 -11 -8 -5 -2 1 4 7 10 13 16 19

Cum

ulat

ive

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thly

Ret

urn

(Inde

x =

1)

Month

pre-spike period

spike event period

post-spike period

Source: Barclays POINT, Datastream, Global Financial Data, PGIM IAS. Past performance is not a guarantee or indicator of future results.

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March 2020

§ For 15 spike events, the average S&P 500 maximum drawdown was -14.5%§ The average cumulative total returns by the ninth month following the spike month

was 3.1%

Spike Events: Maximum S&P 500 Drawdowns

Source: Datastream, PGIM IAS. Past performance is not a guarantee or indicator of future results.

S&P 500 Max Drawdown & Cumulative Performance by Ninth Month following Spike Month(16 Spike Events)

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

-2 0 2 4 6 8 10

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ulat

ive

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thly

Ret

urn

Month

Average drawdownin spike event = -14.5%

Average cumulative price return by 9th month

following beginning of spike event = 3.1%

spike month

Global Financial Crisis

Black MondayGlobal

Financial Crisis

European Sovereign

Crisis

Black Monday

Note: This figure shows the maximum drawdown for the S&P 500 (after month t0-2) and the month of the maximum drawdown, for the 16 spike events. In addition, the figure shows the S&P 500 cumulative total returns (month t0-1 through month t0+9) for each event.

Russian / EM Financial Crisis

European Sovereign

Crisis

Global Financial Crisis Russian / EM

Financial Crisis

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March 2020

§ Large Volatility Spikes Are Not That Uncommon!- About once every 3-4 years

§ Poor Performance during Spike Events Is to Be Expected:- Equity and spread market performance is very poor during the Spike Event itself

§ Markets Recover:- However, these markets response relatively quickly and recover, on average, back to pre-

Spike levels within 9m of the Spike Event

§ “Stay the Course”- Our findings support investors who intend to “stay the course” following a volatility event (i.e.,

do not de-risk) and possibly rebalance to increase allocation to risky assets

CIO Takeaways

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March 2020

Paper Available on www.pgim.com/IAS

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March 202014

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IAS 0325-200

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