A PERSPECTIVE ON CURRENT STOCK MARKET VOLATILITY
Summary Points
- The VIX Index is a market determined measure of equity volatility. In October it reached levels seen only a handful of times in the past 20 years. Fears of a European banking crisis caused by potential sovereign debt defaults has kept equity investors on edge.
- Unlike previous episodes of high volatility, the stock market today cannot be viewed as wildly overvalued. This time the fear is that good profits and strong balance sheets will not be enough to protect companies from a potentially severe macroeconomic event. We should not discount how important the memory of 2008 is in shaping today’s nervous state.
- Accompanying the higher general volatility has been an increase in correlations between stocks. This may in part be due to the changing institutional nature of the stock market where ETFs and high-frequency traders are responsible for an increasingly large percentage of trading.
- There are no quick fixes on the horizon for the macroeconomic challenges around the world. The high volatility and correlations are likely to be with us for some time. Long-term investors need to focus on fundamentals and not allow emotions that arise from short-term volatility to dominate their investment thinking.
The chart above shows the 20 year history of the VIX Index, a market determined measure of volatility expectations for stocks in the S&P 500. With great macroeconomic uncertainty surrounding the European debt situation, and the potential for severe stress across European banks that hold large amounts of sovereign debt, market anxiety and consequently the VIX Index have recently been at levels only seen rarely in the last 20 years.
The three other times that VIX has exceeded 40 were in 1998 at the height of the Asia crisis and the collapse of LTCM, in 2002 as the market aggressively sold off from the tech bubble, and in the financial crisis of 2008. In all three of the previous episodes the stock market began at elevated levels, highly vulnerable to the surprise of bad news.
Most commentators today do not see the world's major stock markets as wildly overvalued. Corporate profits are generally strong and balance sheets are in good shape. This elevated volatility appears to reflect fear that macroeconomic events currently focused in Europe could quickly spread to North America, Asia, and the entire developing world, dragging healthy companies backwards. After a very tough third quarter, a lot of potential bad news may already be reflected in today’s valuations.
Another factor that cannot be quantified is the influence of investors’ recent memory. The credit crisis of 2008 and the subsequent market meltdown left such a vivid impression on most market participants that they cannot help but analyze current events through the lens of that dramatic period. This no doubt causes some to be willing to pay higher premiums for options that provide insurance against extreme market events.
Another important characteristic of the current market is the high correlation between individual stocks. Some ascribe this to a mentality of "risk on" and "risk off" trading. Money is moved into or out of the market less on a stock by stock basis and more in large baskets reflecting market sectors or the market as a whole. Some have pointed to the increased activity in exchange traded funds (ETF's) and the high percentage of volume attributable to high-frequency traders as a source of this correlation.
ETF's are a modern financial phenomenon that we first wrote about in a Commentary exactly two years ago. Updating the information from that report with data collected by Raymond James, there are now over 1300 ETF's traded, double the number in 2007 and 10 times the number in 2003. The assets in these ETF's stand at approximately $1 trillion. Critics of this growth argue that ETF's encourage rapid trading because they are available throughout the day, in contrast to open ended mutual funds that always transact at the end of the day’s NAV.
People with little understanding of how the stock market works have recently made high-frequency traders their favorite culprit behind every perceived market ill. There are many different styles of high frequency trading, so broad generalizations are quite dangerous. The most prominent are firms that make highly automated, two-sided markets, which are the 21st-century equivalent of the stock exchange specialist. There is a growing academic literature that suggests that bid ask spreads are smaller and transactions costs lower today because of this activity. It is hard to make any logical connection between these trades and higher stock-to-stock correlation.
There are also, however, highly automated computer-based traders who look for anomalies in relative price relationships. For example, historical data may show that on average Citicorp and Bank of America stock tend to move similarly over the course of a day as they respond to common market forces. If one stock goes up or falls independently of the other, past history may suggest a trade that has a good probability of profit. Since high-speed computers monitor all transactions in real time it is easy to see how many traders following such algorithms can actually produce higher correlations.
Investors who rely on fundamentals to make their trading decisions find these higher correlations maddening. It is particularly difficult on long/short equity hedge funds as both their good company longs and bad company shorts move together. It is perhaps not surprising in this environment that long/short equity is the worst performing strategy among hedge funds through the first three quarters in 2011.
It is impossible to accurately gauge how much of today's increased volatility or correlations is due to high-frequency and ETF trading. There are too many other forces at work to isolate any direct effects. Everyone wants a “solution.” But we should tread carefully on the path of finding cures, as many ideas floated to date like large transactions taxes are no doubt worse than the disease.
People find themselves emotionally whipsawed by the current environment. As macroeconomic uncertainty in Europe and the United States is unlikely to dissipate any time soon, we should expect the challenges in the market to continue. Investors need to stay focused on their long-term portfolio themes and to not let the market noise sway them from their goals. Dry powder, and a willingness to use it, can be particularly helpful during volatile times to exploit the more extreme moves that are likely still before us.
The bad news is that safe investments still earn negative real rates of interest, so there is no place to hide and make any returns. The good news is that unlike previous periods of high volatility over the past two decades a lot of uncertainty and fear are already priced into the market. Risk assets will continue to remind us why they are so named, but they will also offer the best opportunities for portfolio growth.
This document is intended for informational purposes only and contains the opinions of Offit Capital Advisors LLC. Nothing herein constitutes an offer to sell, or solicitation of an offer to purchase, any securities, nor does it constitute an endorsement with respect to any investment area or vehicle. This presentation is subject to revision, modification and updating. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed. This presentation is confidential, and is intended only for the person to whom it has been delivered. Under no circumstance may a copy be shown, copied, transmitted, or otherwise given to any person other than the authorized recipient (unless required by applicable law). © 2011 Offit Capital Advisors LLC