Volatility has certainly ticked up in recent years—and particularly in the last month—as the financial crisis and economic uncertainty has set in. But are we truly seeing the dawn of a new and more volatile era, or are investors so jittery we have lost perspective?
A look at history shows the latter is the case. On Wall Street, there is very little new under the sun. 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.
Consider the chart below, which shows the daily price changes of the Dow Jones Industrial Average. The first is the 1987 stock market crash, caused by “portfolio insurance” programs run amok. But ignoring 1987, we see something that looks a little like a barbell.
Volatility was high in the late 1920s and throughout the Great Depression decade of the 1930s before entering nearly four decades of relative calm. Stocks got a little more volatile in the 1980s, returned to relative calm for much of the 1990s, and then all hell broke loose.
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. Volatility died down a bit during the mid-2000s … and then exploded as the mortgage crisis struck.
Today, there is a lot of finger-pointing as to whom or what is responsible for the uptick in volatility. Austrian economists—who have enjoyed a high profile after Tea Party presidential candidate Michele Bachmann recently remarked that she read Von Mises on her beach vacations—might argue that excess liquidity and ultra-loose Fed policy are to blame. There is certainly some amount of truth to this. 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. But liquidity alone cannot explain the roller coaster ride of recent years.
In a recent New York Times, Louise Story and Graham Bowley note that large market swings are becoming a lot more common than they used to be, referring to an analysis of daily stock price changes going back to 1962. The authors suggest that high-frequency trading could be to blame.
This is also an oversimplification. The “high-frequency trader” 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—within minutes.
High-speed quantitative traders are nothing new, of course. But in recent years, they have come to control as much as 60% of daily trading volume, which is fine—except when they all vanish at once and cause liquidity to disappear, as they did during the Flash Crash. To this day, there has never been an adequate explanation for what “caused” the Flash Crash, and that is unfortunate because that event—even more than the post-2008 bailouts—proved to many investors that they are indeed playing a game that is rigged against them.
Commodities markets, however, are worth examining for their role in the current mayhem. The havoc that commodity ETFs are wreaking on metals, energy and materials prices is a topic I have covered recently (see “The Myth of Commodities Investment” for more.)
The commodities markets have fallen victim to “financialization.” It is the capital markets—composed of everyone from multi-billion-dollar hedge fund traders to do-it-yourself individual investors—that now set prices, 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 “guestimate” what real demand is and adjust their production accordingly. But while commodity prices are indeed a big market mover, they do not determine the whole story on Wall Street.
It may be hard to admit, but history suggests that this current volatility too shall pass. Markets have a way of adapting, eventually, and I see no reason why this time is different.
Still, this doesn’t mean that the volatility cannot persist for months or even years.
While it’s difficult to invest with confidence in this kind of market, investors can use the volatility as an opportunity. 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—the kinds of businesses that will survive and thrive in any economic conditions (see “Why Ugly Sisters MSFT and INTC are Buys of the Decade”).
For investors with a long time horizon and a healthy amount of emotional detachment, volatility is nothing to be afraid of. We should consider those immortal worlds of Warren Buffett: “Be greedy when others are fearful and fearful when others are greedy.”
Given the fear out there, I would say a little greed is in order.
Charles Lewis Sizemore, CFA is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. Sign up for a FREE copy of his new Special Report: “3 Safe Emerging Market Stocks for a Shaky Market.”