{"id":23901,"date":"2011-09-16T17:32:51","date_gmt":"2011-09-16T21:32:51","guid":{"rendered":"http:\/\/countingpips.com\/fx\/2011\/09\/16\/volatility-so-old-its-new-again\/"},"modified":"2011-09-16T17:32:51","modified_gmt":"2011-09-16T21:32:51","slug":"volatility-so-old-its-new-again","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/fx\/2011\/09\/16\/volatility-so-old-its-new-again\/","title":{"rendered":"Volatility: So Old It\u2019s New Again"},"content":{"rendered":"

By The Sizemore Letter<\/a><\/p>\n

Writing for the New York Times<\/em>, Louise Story and Graham Bowley note that large market swings are becoming a lot more common than they used to be.\u00a0 (See \u201cMarket Swings are Becoming New Standard<\/a>\u201d)<\/p>\n

\u201cIt has become more likely for stock prices to make large swings\u2014on the order of 3 percent or 4 percent\u2014than it has been in any other time in recent stock market history,<\/strong>\u201d write Story and Bowley, referring to NY Times analysis of daily stock price changes going back to 1962.<\/p>\n

But while volatility has certainly ticked up in recent years\u2014and particularly in the last month\u2014there is very little new under the sun.\u00a0 Markets tend to go through long periods of relative calm interrupted by violent outbreaks of volatility that can last from a couple days to a couple years.<\/p>\n

Consider Figure 1<\/strong>, which shows the daily price changes of the Dow Jones Industrial Average.\u00a0 A couple things immediately jump off the page.\u00a0 The first is the 1987 stock market crash, caused by \u201cportfolio insurance\u201d programs run amok.\u00a0 But ignoring 1987, we see something that looks a little like a barbell.<\/p>\n

\"\"<\/a><\/p>\n

Figure 1<\/p>\n<\/div>\n

Volatility was high in the late 1920s and throughout the Great Depression decade of the 1930s before entering nearly four decades of relative calm.\u00a0 Stocks got a little more volatile in the 1980s, returned to relative calm for much of the 1990s, and then all hell broke loose.<\/p>\n

There was a surge in volatility during the late 1990s that coincided first with the Long-Term Capital Management meltdown and then the dot-com bust and the fallout from the September 11, 2001 terror attacks.\u00a0 Volatility died down a bit during the mid-2000s\u2026and then exploded as the mortgage crisis struck.<\/p>\n

\"\"<\/a><\/p>\n

Pondering Von Mises, no doubt<\/p>\n<\/div>\n

Today, there is a lot of figure-pointing as to whom or what is responsible for the uptick in volatility.\u00a0 Austrian economists\u2014who have enjoyed a high profile after Tea Party presidential candidate Michele Bachmann recently remarked that she read Von Mises on her beach vacations\u2014might argue that excess liquidity and ultra-loose Fed policy are to blame.\u00a0 There is certainly some amount of truth to this.\u00a0 The liquidity provided by the Fed has a way of seeping into the financial markets, where it can play the role of gasoline poured liberally onto a bonfire.\u00a0 But liquidity alone cannot explain the roller coaster ride of recent years.<\/p>\n

In the New York Times<\/em> article, Story and Bowley suggest that high-frequency trading and the proliferation of new exchange-traded funds (ETFs) are to blame.<\/p>\n

The \u201chigh-frequency trader\u201d has grown into an almost mythical boogeyman in recent years and particularly after the May 2010 Flash Crash, in which the Dow dropped 1,000 points within minutes and then gained most of it back\u2014within minutes.<\/p>\n

High-speed quantitative traders are nothing new, of course.\u00a0 But in recent years, they have come to control as much as 60% of daily trading volume, which is fine\u2014except when they all vanish at once and cause liquidity to disappear, as they did during the Flash Crash. \u00a0\u00a0To this day, there has never been an adequate explanation for what \u201ccaused\u201d the Flash Crash, and that is unfortunate because that event\u2014even more than the post-2008 bailouts\u2014proved to many investors that they are indeed playing a game that is rigged against them.<\/p>\n

Given the size and liquidity of global stock markets, I remain skeptical about the effects that ETFs are having on volatility.\u00a0 But the commodities markets are an entirely different story.\u00a0 The havoc that commodity ETFs are wreaking on metals, energy and materials prices is a topic I have covered recently in Sizemore Insights<\/em> (see \u201cThe Myth of Commodities Investment<\/a>.\u201d)<\/p>\n

The commodities markets have fallen victim to \u201cfinancialization.\u201d It is the capital markets\u2014composed of everyone from multi-billion-dollar hedge fund traders to do-it-yourself individual investors\u2014that now set prices and not the supply and demand dynamics of real producers and consumers. This renders the all-important price signals all but meaningless. Producers are thus left to \u201cguestimate\u201d what real demand is and adjust their production accordingly.<\/p>\n

Edward Hadas recently recounted a joke told by disenchanted Soviet era economists that I think is appropriate:<\/p>\n

Soviet patriot: \u201cThe USSR will invade and conquer every country in the world, except New Zealand.\u201d <\/em><\/strong>
\n\u00a0<\/em><\/strong>
\nCurious observer: \u201cWhy leave New Zealand out of the global communist economy?\u201d <\/em><\/strong>
\n\u00a0<\/em><\/strong>
\nPatriot: \u201cSo we can find out the market price of goods.\u201d<\/em><\/strong>\u00a0 (To view Hadas\u2019 full article, follow this link<\/a>.)<\/p>\n

Lenin and Stalin must be laughing at us from hell right now. The West might have won the Cold War, but Soviet-style central planning has become the de facto method of setting commodity production because the capitalist system has become perverted beyond all recognition by its own capital markets.<\/p>\n

What are we to take away from all of this?\u00a0 Will volatility be \u201cpermanently\u201d higher, as Story and Bowley suggest?<\/p>\n

History suggests that this too shall pass. \u00a0Markets have a way of adapting, eventually, and I see no reason why this time is different.\u00a0 Still, this doesn\u2019t mean that the volatility cannot persist for months or even years.<\/p>\n

While it\u2019s difficult to invest with confidence in this kind of market, investors can use the volatility as an opportunity.\u00a0 Investors that keep a little cash in reserve can use the violent downdrafts in the market to accumulate shares of high-quality, dividend-paying companies\u2014the kinds of businesses that will survive and thrive in any economic conditions (see \u201cWintel: The Ugly Sister and the Buy of the Decade<\/a>\u201d).<\/p>\n

For investors with a long time horizon and a healthy amount of emotional detachment, volatility is nothing to be afraid of.\u00a0 We should consider those immortal worlds of Warren Buffett: \u201cBe greedy when others are fearful and fearful when others are greedy.\u201d<\/p>\n

Given the fear out there, I would say a little greed is in order.<\/p>\n

Related Post: Risk, Return, and Reality Revisited <\/a><\/p>\n

If you liked this article by Sizemore Insights<\/em>, you\u2019d probably enjoy The Sizemore Investment Letter<\/em>, our premium members-only newsletter. Click here<\/a> for more information.<\/p>\n","protected":false},"excerpt":{"rendered":"

By The Sizemore Letter Writing for the New York Times, Louise Story and Graham Bowley note that large market swings are becoming a lot more common than they used to be.\u00a0 (See \u201cMarket Swings are Becoming New Standard\u201d) \u201cIt has become more likely for stock prices to make large swings\u2014on the order of 3 percent … <\/p>\n

Continue reading “Volatility: So Old It\u2019s New Again”<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[],"tags":[],"class_list":["post-23901","post","type-post","status-publish","format-standard","hentry"],"_links":{"self":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts\/23901","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/comments?post=23901"}],"version-history":[{"count":0,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts\/23901\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/media?parent=23901"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/categories?post=23901"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/tags?post=23901"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}