The twitchy, volatile stock market

By Felix Salmon
August 12, 2010
stock market fall today, but it was certainly important enough to grab the attention of Mohamed El-Erian, who has an interesting theory of why it happened:

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I did my best to ignore the stock market fall today, but it was certainly important enough to grab the attention of Mohamed El-Erian, who has an interesting theory of why it happened:

As Rich Clarida and I recently argued in the FT, sharp risk-on/risk-off swings in markets are to be expected given the reality of today’s macro context.

A couple of weeks, Fed chairman Ben Bernanke called the outlook “unusually uncertain“. We went further, arguing that expectations of outcomes have evolved in an interesting manner – from the more familiar bell curve (a dominant mean and thin tails) to a much flatter distribution with fatter tails. In such an expectation world, short-term news can have a disproportionate impact on market valuations.

Essentially, El-Erian is saying here that the markets have gone from driving a boring family sedan to driving a twitchy, ultra-responsive sports car. And that’s nothing to do with high-frequency algorithmic trading, or anything like that — such things only serve to exacerbate the underlying fundamentals.

Think about it this way: In the 1950s, or even in the 1980s, the range of possible outcomes was (or was perceived to be) pretty narrow. As the macroeconomic situation evolved in a relatively simple and continuous manner, markets evolved to reflect the new realities. Even the bout of high interest rates and inflation in the 1970s was something that equity markets, in particular, could take in their stride — stocks are, after all, one of the world’s better inflation hedges.

Today, however, we live in a much more discontinuous and uncertain world. If stocks are pricing in a 10% chance of a devastating bout of deflation and that perceived probability rises to 20%, the risk-adjusted present value of those stocks can plunge dramatically — much more than 3% — even if everything else remains the same. We don’t really have a model of how the economy works (or doesn’t) — but insofar as we do, it’s one of those models where small changes in initial assumptions can and do result in very large changes to outputs.

As a result, the long-term volatility of equities is going to continue to rise, I think, as it has been rising of late. (Does anybody have a dataset here? I’d love to see a chart of at-the-money implied 10-year or 15-year volatility for the S&P 500, and not just because it has important implications for Warren Buffett’s equity puts.) The implication of that is that the “long run”, in the concept of “stocks rise over the long run”, is going to continue to get longer and longer. It’s clearly not 10 years, any more, or even 15. But how long is it? 35 years? 50? And at what point is that long run so long that it’s of practical purpose to pretty much no one?


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So you’re saying we should be glad you did your best to ignore the stock market today?

Posted by flippant | Report as abusive

Surely, if we are moving back to a period of low growth or deflation then stock investments should be made for the income they make, not because of the hope of getting speculative levels of capital growth? Since stocks are such a good hedge against rising inflation, it should be expected that deflation will result in falls in stock prices generally. That is, if deflation is to be expected for the long term.

It should be remembered that it was only when pre-War pension fund managers started investing in stocks that they became mainstream investments for everyman. Why did they invest? Because the yields on stocks were higher than those for bonds. It had nothing to do with the hope of capital gains, that came as a side effect.

Posted by FifthDecade | Report as abusive

You have again conflated implied and realized vol, just as you did in the GS post before your vacation. Just how much liquidity do you imagine is out there at the 10Y and 15Y points you want? Quotes for these will be completely dominated by supply and demand imbalances which have only the most tenuous connection to anybody’s “expectations” of future realized vol.

You have (correctly, in my view) expressed skepticism about the expected equity returns implied by current valuations. So why are you willing to swallow implied vols hook line and sinker, as though God handed them to Moses engraved on stone tablets?

Posted by Greycap | Report as abusive

You’re ignoring the reality of the information age.
Stocks are ‘twitchy’ now because they are FAST. In the 50′s, the insiders found out something, then the analysts, then the brokers, then the man on the street. Buys and sells were done via phone calls, volume was low, shares puttered back and forth.
Now what is happening? News is announced, and shares explode by the millions across the lines as HFT’s and companies trade, deal in hedging, try to sell ahead of or behind the curve, invent a new derivative to take advantage of the movement, and day traders at home have access to more information then brokers had back in the day.
The market moves because more people then ever have access to information and news that affects the markets, and don’t need 3 and 4 intermediaries to move their money around anymore.
The speed of information and the ability of everyone to access the market are what makes the market twitchy. It used to take months for bad news to ripple across a stock and the market to have an effect. Now, the slightest news is calculated in instantly, and we have change. That’s volatility.

Posted by REDruin | Report as abusive

Trading has also become cheap. A small-time investor moving chunks of $10,000 around can make an in-and-out swap for $16. Twenty years ago, you would have been looking at smaller chunks of money and commissions that were five times as high.

I suspect there are also many more people trading on short-term technicals than there used to be. Investors with a long-term outlook don’t sweat the daily news. Day traders care about nothing but, so you see big swings back and forth.

Finally, our perception is heavily skewed by the tech bubble in 1995-2000. The S&P500 tripled in five years, clearly outpacing earnings growth over that time, so it isn’t surprising that it has taken a while for earnings to catch up. I wouldn’t expect rapid growth going forward, but at least we don’t have a valuation overhang to work off like we did ten years ago. RIGHT NOW, I think you can safely invest in quality stocks if you have a ten-year horizon.

Posted by TFF | Report as abusive

may i just add what may appear a naive comment, long term
investment as opposed to a trading position have now taken on completely different time horizons,than what until relatively recently was considered acceptable/reasonable. this may be due in some (tho not necessarily small) measure to market information availability, rather i think it to be more related to high frequency , algorithmic trading platforms which take the entire market segment up or down (as the embedded chip may define). this will in turn affect the monthly / quarterly returns on managed portfolios or pensions.
whilst i may yearn for the old days where one could look to a 1,2 5 year time horizon, i think we must now all get used to a 1,2,5 Day time line as we either willingly or unwillingly guage returns against benchmarks rather than what we may instinctively consider right. for the record, my portfolio is primarily FTSE 100
with a trailing P?E of about 10 and a yield of something north of 6.25 pct in GBP terms….. or it was at the time i started writing this piece….but that could have changed….

Posted by billuk1 | Report as abusive

billuk, there is enough money (and brains) chasing short-term returns these days that I doubt there is any profit to be made there for retail investors.

Instead, you need to LENGTHEN your horizon. Ask yourself, “What companies are almost certain to be more profitable in 2020 than they are today?” That’s a long enough time frame that with today’s peripatetic markets you are likely to see at least one bull market and at least one bear market. Surely a major recession or two, somewhere in the world.

But at today’s valuations, if you can be certain that the company will be 50% more profitable in a decade than it is today (CAGR of 4%), then you can assure yourself of at least a LITTLE capital appreciation over that time, with nice dividends between now and then.

People have forgotten that approach because it didn’t work — couldn’t apply — at the valuations we saw between 1998 and 2008. We have an entire generation of investors trained to look short and trust that rapid growth will take care of the future. When that rapid growth eventually stalled (as it always does), those bets failed.

Now we are awash in stock investments that make sense at simple 4% earnings growth. I’m betting they can achieve THAT target, on reinvested earnings and inflation alone.

Posted by TFF | Report as abusive