LONDON, Aug 9 (Reuters) - What looks like a financial

market in disarray may instead just be normalization that will

ultimately help insulate investment portfolios rather than

sending them to the ground.

There's little doubt that a bubble has been burst in the

wild swings of the past week.

But that bubble was mostly in high-octane trades that not

only hinge on low market volatility but can also help keep

volatility low - at least for a while. So what we may be seeing

now is volatility returning rapidly, if noisily, to historically

familiar levels.

And regular investors should take some comfort in the way

most traditional mixed asset portfolios behaved in the upheaval.

For the past year, stock and bond prices have mostly ebbed

and flowed in tandem. Such positive correlation has long been a

big fear for many, as it reduces the benefit of holding both

asset types. But what we just saw is a switch back.

Bonds and equities once again functioned more as natural

hedges for each other, partly insulating plain vanilla "60/40"

equity/bond mixes in the process.

As the S&P 500 index plunged by as much as 8% from

the start of the month to Monday's trough, Treasury bond price

indexes jumped about 4%.

That's still an overall hit for a traditional 60/40

investor, but much less painful than the damage such extreme

stock moves could have caused. This is critical in avoiding the

type of fearful "de-risking" of investment portfolios that could

well fuel the very economic downturn it seeks to sidestep.

In other words, the "good news is bad news" trading bias has

flipped again.

For the past two years of high inflation and interest rate

rises, anything that aggravated that picture tended to hit

borrowing costs, bonds and stock prices at the same time.

But that seems to have changed now that inflation is almost

back near the U.S. central bank's target and Federal Reserve

Chair Jerome Powell's hands are untied. Periodic worries about

economic growth - like the surprisingly large jobless rate

increase seen last week - may weigh on pricey equities but also

lift bond prices because they raise the chance of Fed easing.

What's more, we also seem to be seeing the normalization of

the pivotal "fear index" - Wall Street's VIX index of

equity volatility. It appears to be reverting to its historical

norms following Monday's explosion after staying well below

normal for nearly 18 months.

And trading of VIX futures that expire at the end of this

year has calmed following the record one-day rise in the index

itself. They have settled back at levels almost exactly at the

30-year average.

As GAM Investments strategist Julian Howard commented on

Thursday: "Market volatility goes with the territory and is not

a reason for mass hysteria."

HISTORIC OR HYSTERIC?

This rapid reset offers few clues about the likelihood of

recession ahead or the sustainability of the heady valuations of

Big Tech megacap stocks and their new AI toys.

But it helps recalibrate markets away from the type of

extreme positioning that makes shocks more likely when there are

challenges to consensus thinking. The most recent such

assumption, of course, is the idea that we would see an

everlasting economic expansion that low-volatility trades could

continue to binge on.

On the recession score, consider that JPMorgan's latest take

is that there is a roughly one-in-three chance of a U.S.

recession over the coming year. That somewhat bearish call still

assumes that the most likely outcome is a "soft landing" in

which inflation is tamed without triggering a painful recession

or sharp rise in unemployment. And remember there's normally a

20% probability of a recession for any given year ahead.

With the Atlanta Fed's real-time "GDPNow" model still

tracking U.S. growth as high as 2.9% for the current quarter,

recession next year remains a brave outside call.

What seems more certain is that the Fed will start cutting

rates next month regardless, mainly as it deems its current

"real" policy rate to be too restrictive for a softening labor

market now that inflation is back under control.

The extent of that easing cycle may be less than what's

suggested by the freefall in Treasury yields and money market

bets this week. But the Fed's ability to head off the downturn

with lower rates packs a punch for equities either way.

Franklin Templeton Institute's Stephen Dover points out that

the average one-year stock market return after the first Fed

rate cut is almost 5% even when a recession occurs. And it's

16.6% when the cuts come without a recession.

On the other hand, pricey stock valuations and doubts about

artificial intelligence in an environment with more normal

volatility and increased recession fears may make investors

holding mixed asset funds rebalance away from equities.

If that shift unfolds, it could whip up a big headwind for

stocks.

JPMorgan analysts point out that despite the past week's

share price plunge, equity allocations globally remain well

above average. If these valuations were just to return to the

average of the past decade, they posit that stock prices could

fall another 8%.

And big volatility explosions always run the risk of having

ripple effects, not least because jittery investors may start

asking a basic question: "what if it happened again?"

"The biggest takeaway from this week's price action is that

all risk managers will now have to model a 50-point rise in the

VIX within two business days, forcing every sensible investor to

deleverage," Societe Generale's Jitesh Kumar and Vincent Cassot

observed.

Then again, maybe risk managers should always have suggested

such extremes were possible.

So despite all the sound and fury of recent days, the noisy

return of more "normal" market behaviour may well leave

investors with a safer and more sustainable environment all

around.

The opinions expressed here are those of the author, a columnist

for Reuters.

(by Mike Dolan X: @reutersMikeD; Editing by Paul Simao)