Why Stock Market Volatility Is Perfectly Natural

With the Dow down another 300 points this morning (yawn), we're all getting used to stock-market volatility. Traders are all psychologists now:

"Psychology and emotion are a big part of what moves the market," said Andrew Brooks, head of stock trading at T. Rowe Price. "We are clearly in a highly emotional and schizophrenic point."

The weird thing is that this feels perfectly natural to me, coming as I do from the world of fixed income.

Bonds are easy things to value: Plug a cashflow, a default probability, a recovery rate, and a risk-free rate into your Bloomberg, and it'll happily spit out an unambiguous price which all bond traders can agree on. They might disagree on the inputs, but given the inputs, they won't disagree on the outputs.

Equities, by contrast, are another world entirely. How do you even begin to value such a thing? Companies' cashflows aren't fixed, in the way bond cashflows are: by contrast, they're highly uncertain. But investors can't even agree on the cashflows they're looking at: Ebitda? Earnings? Dividends? Theoretically, using any of these indicators should land someone in exactly the same place as using any of the others. In practice, that's not the case -- especially not if you start thinking about companies like Berkshire Hathaway (BRK.A) which don't pay any dividends at all.

And then of course there are all those other ways of valuing companies, too. Book value and Tobin's Q, all manner of internal ratios, proprietary metrics which hedge funds never reveal. During the dot-com bubble, an entire industry sprang up devoted to reverse-engineering valuation models which could conceivably spit out the numbers seen in the stock market. It was a successful industry, too.

In most of these models, a small tweak of a growth rate here or there is likely to have an enormous effect on a stock price, and no one can possibly predict future growth rates with nearly enough accuracy to get a remotely useful bead on where any given stock should be trading. Ultimately, there's only one reliable way of valuing a stock, and that's to look at where it's trading in the secondary market.

But given how uncertain a stock's fundamental value is, there's no reason why its secondary-market value should be precise to within a tiny margin like 1% either way. A move of 3% or 5% or even 9% in either direction is perfectly reasonable, especially when the macroeconomic outlook is hazier than ever. (You try finding anybody willing to forecast US GDP growth over the coming year with any confidence.)

So what's happening now is that stocks are fluctuating in a very big grey zone -- what you'd expect, given overall levels of doubt and uncertainty about the future. And now more than ever, the daily direction that stocks move doesn't mean anything. They're down today but they might have been up: whatever. It's their nature to be fuzzy. You don't need to be "highly emotional and schizophrenic" to get here, you just need to be clear-eyed about all the things you don't know.

Comments

[MarvinMBA:]

All the things you do not know I will now tell you:

WE ARE IN DEEP TROUBLE WITH THE ECONOMY WHICH IS GOING TO
TANK MORE AND MORE AS WE GO THRU THE NEXT FEW QUARTERS.

The big question is can a stockbrokerage and banking system run by the government be productive for the investor?? My answer: NO NO NO.

Are we going to socialize the Auto Industry next????

2008 Oct 22 01:30 PM

[MarvinMBA:]

I personally suggest
that the coming months and years will see vast changes in the world economy and social
structure with this country coming out second rate. We are so spoiled that everybody
thinks everything will just flow down from heaven. We have to provide the right intrastructure for
success and that means low cost or no cost education thru college, medical
assistance for everybody and low cost energy. LETS CALL A
SPADE A SPADE AND NOT LIVE IN THE FUTURE LIKE WE HAVE BEEN LIVING.

2008 Oct 22 01:44 PM

[Smarty_Pants:]

"I believe that there cannot be a Reform Republican with new ideas ": User 118015

There was: Ron Paul.

He was ignored, trivialized, and ridiculed by everyone but those who chose to listen and think about what he said, until he stopped trying.

Suddenly, when all the things he said were going happen have started happening, he's the media's answer man.

Granted, electing Ron Paul wouldn't have made our current problems disappear. They're to large a part of our economy to simply vanish. He would have at least been honest about what's wrong and done what he could to let the market correct the malinvestments of the past 30 years.

What the American public wants and needs is truthfulness. We are tired of political hair-splitting campaigns that lead us to eventual ruin while enriching those who are cronies and insiders.

2008 Oct 22 02:00 PM

[Smarty_Pants:]

Felix:

Thanks for using 'volatility' in the proper context, ie. large swings up AND/OR down in a short time interval.

Too many of the bobble-head financial commentators and news analysts have for too long used the term "volatility" as a euphemism for "the market is going down" in an effort to avoid any negativity in matters financial.

Thus 'official' news reporting recognizes two states for the market:

1) rallying
2) volitile

Those are apparently our only choices if we are to believe CNBC and the like.

2008 Oct 22 02:05 PM

[moonbat1775:]

Ron Paul would have brought true confidence to our system. I am writing him in this election so the "lamestream" media will not ignore him in 2012.

2008 Oct 22 02:09 PM

[catskill:]

Why is "socialize" such a bad thing? They don't FORBID profits - just let's please keep just a few things in tact...people are greedy by nature, we all need a track to run on and we can all make our "smaller" profits and go home happy, instead of this chaos, that's all. Don't be so scared....change CAN be good for everybody.

2008 Oct 22 03:22 PM

[Frank Miller:]

This may be true, but for most investors negative volatility is not what they want to here. Check out today for example: another tough day for the market. Down over 500 points....We all know we will continue to have a number of bad days with a few rebound days. Bottom line: the US markets are too unstable in the near future. Investors really need to make changes to their investing strategy if they have not already, especially since the market has not hit the bottom yet.. This means move money into T-bills and municipal bonds and invest some overseas to guard as a hedge against the coming inflation of the US dollar. I use offshore bank accounts for this and they have helped me. If you would like to learn more, feel free to visit my site.

Best,
Frank Miller

2008 Oct 22 04:19 PM

[User 265729:]

Markets are a joke.

Felix, Felix, Felix. How many times have we head the phrase "market bottom" on TV, the WWW and right here on this site? The "V." Doesn't look like any V-shape I've ever seen.

This type of volatility is NOT NORMAL. If it were, why would volatility indexes be at record highs? This market volatility may be normal, in a Third World country somewhere! This is unknown to markets in the United States.

Swings of 1,000 pts or more interday. Normal? You can't be serious?

This is a phony market, being worked by phony politicians and phony CEO's. Now, before Congress, we find that these rating agencies are also phony. Yes Felix, everything is a "Strong Buy." It is all laughable, unless you put your eggs in this basket.

Felix, I could get a three year old, give him an Etch-A-Sketch, and give you a more accurate market outlook for the next decade. It will look, very much like today's intraday.

2008 Oct 22 04:20 PM

[User 265729:]

Felix,

I did see ONE comment by a rating agency that made sense... "BUY" on HRL (Hormel Foods).

At this rate we will all be living off of canned Spam in that not too distant future.

Disclosure: No position on HRL, nor do I send Spam e-mails.

2008 Oct 22 04:25 PM

[sickofthehype:]

Sick of the bickering between our two parties - they're becoming so similar it's a joke. Sick of the biased media. Sick of 'analysts' who are paid off and wrong most of the time. Sick of the blame game and nobody taking responsibility. Sick of fudged numbers, balance sheets, financial statements. Sick of CEO's who know diddly about anything but their own greed. Sick of the fact that you can't trust anyone but yourself. Sick of morons in foreclosure blaming the banks when it was their own judgment to take on the debt that they did. Sick of hearing about the doom and gloom and the negativity and the BS.

2008 Oct 22 05:09 PM

[CM in MA:]

Good article but a poor title. An observation: there is no "normal" for volatility. Low or high, it is what it is. If we had a functioning thermometer that could measure wide temperature swings, would the thermometer be normal on the planet Mercury or Pluto? Answer: it would be normal (functioning) on both. Like volatility, the temperature is what it is. The thermometer simply permits us to measure it. What would be abnormal is a low volatility measurement when prices are swinging widely, or vice versa (i.e. a broken thermometer). It has been noted that we use the wrong distribution for analyzing return data (Taleb). This causes us to think, at least subconsciously, of volatility as a constant (i.e. a human temperature) when it isn't any such thing.

2008 Oct 22 08:38 PM

[Jimmy Lathrop:]

You know you have written a good article on Seeking Alpha when the first five comments incorporate ALL CAPS RANTING, finger-pointing at the administration, a Ron Paul Plug, and someone saying your name 3 times like a gypsy spell.

Oh, and by the way, Felix? Your article? Superb. Thanks again.

2008 Oct 22 08:42 PM

[Socialism c...:]

Bonds may have been easier to price in the past, but not by this degree. What is clear is that Mr. Salmon is overstating the case -- this degree of volatility is *not* normal! And it is due to the federal government continually changing the rules of the game!! The market clearly does not like all the socialism -- that is what is going on right now. And it's why we don't know how to price anything at the moment. If we went by earnings, Q3 is looking fine, outside of Financials, IMO. Going *forward*, however, the socialistic moves and government not allowing capitalism on the down side is what demolishes the ability to price and renders markets non-functional!

2008 Oct 22 10:36 PM

[The AntiCramer:]

User 118015: Let me get this clear. Senators Frank and Dodd, who defended and protected Fanny and Freddy until it was certain that they were doomed are Republicans right? They've since come clean about their grave mistake, correct?

Bottom line is that on one side of the Aisle you have a bunch of criminals. On the other you have a bunch of crooks.

They have one other thing in common: We hired them. We also have the power to fire them.

This election day please don't discriminate between Democrat and Republican. I'm considering voting for all the challengers. If that doesn't work I'm buying a pitchfork and starting a mob.

2008 Oct 22 11:14 PM

[Michael Comeau:]

It seems that many investors have forgotten the fact that stocks are RISKY instruments, and there will always be market periods where things are absolutely insane and seem to make zero sense.

Of course, the government is here with our tax dollars - I'm sure they can fix everything!

2008 Oct 22 11:31 PM

[Josh Stern:]

Investing based on rational assessments of valuation suggests forming such estimates on a bottom up basis for each security, but all of the anecdotal evidence I come across suggests that the percentage of investors/traders who attempt to do that and use it to drive their investing decisions is extremely small - maybe 10%. So discussion of how reasonable people can often disagree about valuation seems moot, because most people focus instead on getting ahead of the buy/sell decisions of other traders using whatever heuristic tools they believe will be most effective to do that - e.g. technical analysis at the individual security level, technical analysis at the index or sector level, historical analogy, theories of market cycles, gaming news flow, etc.

2008 Oct 23 12:21 AM

[Jackson Cash:]

Not going to lie, I sense that the tone is changing in these comments...

People are starting to actually contemplate the gravity of the situation.

Welcome to reality. Now, where is Jason C to tell us how wonderful and uplifting those that got us into this mess are,

2008 Oct 23 02:17 AM

[fxtrader07:]

feix, this is not volatility. this is selling on a grand scale. mass-liquidation. and it has little to do with fundamentals anymore.. the same with corporate bonds, btw. lots of people want to or are forced to exit their positions - at almost any price.
thisa is going to stay here for at least 2 more months imho. yes, fears and uncertainties about economy play a role, too. but only a secondary one.
people simply search for reasons - 'there must be some fundamental reason for the low stock/bond prices'. Yes and no. there isn'tnot for THESE low prices of many (not all) stocks and bonds. except if you expect a complete collapse of the world economy. but then again - the prices of all stocks and bonds are still way too high.
so, markets try to price the probabilty of survival and of armageddon. the human brain cannot think in terms of probabilities. it cannot handle a 70% chance or a 80% or 90%. so you have these wild swings and you have all this liquidation going on.
where will it sto?
i have no clue. it may right here. or 20% lower, or 60% lower. wtf do i know? wzhat i do know though, is that economic armageddon has perhaps a 5% probability. so with 95% probability, most bonds and many stocks will be much much higher a year from now

2008 Oct 23 03:52 AM