Will Stock-Market Volatility Come Back in 2014?

The year 2013 has been an exceptionally strong one for stock market investors, who scored big gains on their portfolios in a broad-based advance in the fifth year of the current bull market. One of the most surprising things about 2013 was that those gains came with very little volatility, with the Volatility Index staying at extremely low levels throughout nearly the entire year as the market, once again, avoided a 10% correction in 2013.

For investors in the volatility-tracking exchange-traded notes iPath S&P 500 VIX ST Futures ETN and VelocityShares Daily 2x VIX ST ETN , the lack of volatility proved disastrous, even as shareholders of the VelocityShares Daily Inverse VIX ST ETN scored impressive gains. But will that same strategy work in 2014, or will volatility finally rear up and return to more normal conditions next year? Let's take a look a closer look at the prospects for volatility in 2014.

^VIX data by YCharts

A painful year for thrill seekers
Coming into 2013, many investors expected the markets to start getting choppier. During 2012, pullbacks at midyear sent the Volatility Index to fairly high levels; yet the often-turbulent autumn months failed to deliver the usual rise in fear, leaving the index without a single reading above 30 for the first time since before the financial crisis. Even the year-end spike in volatility caused by Congressional debate about the fiscal cliff  gave way to a big celebration at the beginning of 2013, when lawmakers reached a successful resolution of the tax-related controversy.

As it turned out, however, 2013 proved to be an even more benign year for volatility than 2012 was. Volatility levels stayed below 22 all year, and the Volatility Index spent much of 2013 at levels not seen since the last year of the previous bull market in 2007.

Volatility ETN Total Return Price data by YCharts

That was good news for stock investors, but for those who bought volatility-linked investments hoping for more fear in the market, 2013 was a painful year. The unleveraged iPath ETN lost two-thirds of its value, while the leveraged VelocityShares ETN dropped more than 90%. Meanwhile, those who invested expecting the lack of volatility saw impressive gains, as the inverse VelocityShares ETN more than doubled.

What to expect in 2014
Obviously, it's impossible to predict what will happen with volatility in 2014. But you can get a hint by looking at the volatility futures markets.

Currently, futures contract prices show that investors still expect a gradual increase in volatility levels throughout 2014. From current levels of just over 12, futures predict a rise above 13 by January, with another point every month thereafter through April. From April to September, futures predict a rise from 16 to about 18.5, which would put volatility above the levels it reached throughout all but a few very brief periods during 2013.

The key to remember, though, is that futures investors have predicted just about exactly that same scenario for a long time now. Indeed, that's a big part of why the inverse VelocityShares ETN has performed so well, as it uses futures contracts to track volatility. Those same expectations have hurt the results of the other volatility-tracking ETNs, with losses that were worse than the corresponding drop in the Volatility Index itself.

Being prepared for volatility is always a prudent course for any investor. Counting on the timing of when that volatility will come, however, is a dangerous bet. Volatility-ETN investors learned that the hard way in 2013, and they'll be reluctant to repeat their experience in 2014.