Another Explanation for Stock Market Volatility

Recently, there have been many articles referring to the equity market’s volatility. Barron’s reported that daily volatility is approaching 1929 levels. Bespoke reported that the recent average daily swing for the S&P 500 is now an astounding 3.8%! Floyd Norris blogs that:

We have just completed two consecutive trading days when the Standard & Poor’s 500-stock index rose more than 6 percent each day — the first time that happened since 1933. They followed the first two consecutive 6 percent declines since 1933.

For the four days, the S.& P. is down 0.9 percent. We may not be accomplishing much, but it sure is a lot of fun.

In this environment, VaR and other risk control estimates all go out the window.

Why is the market so volatile?

There are many explanations for this volatility. The most obvious one is the macroeconomic uncertainty that grips the financial markets. I have noted that many hedge funds have gone to cash for the remainder of the year. Given the decrease in “fast money” trading and the lack of conviction by other market participants, it is not surprising that daily volatility has risen.

Other analysts have suggested more esoteric explanations. Some have turned from the equilibrium models used by many economics to agent based models to explain the swings in the market. Others have modeled stock market volatility using predator-prey models. (Yeah - The early bird gets the worm, but does the early worm get eaten?)

A simpler contributing factor: low stock price

No doubt there is some element of truth in all of these explanations. I would like to suggest a far simpler contributing factor to this market volatility: lower stock price.

Bespoke recently reported that the number of high priced stocks and low priced stocks are at levels seen at the last market bottom in 2002, no doubt a result of the market's severe downdraft. While this market decline creates a far larger universe of Phoenix candidates, the lower price per share of stocks also contributes to increased volatility.

The chart below shows the median standard deviation of one-day returns in the past month for the components of the Russell 3000, categorized by stock price. As you can see, as the per share prices of stocks fall, volatility increases monotonically. Though not shown in the chart, I found that this effect can be seen whether you measure volatility using the standard deviation of daily returns, average daily percentage swings, or the difference between daily high and low.

With the shares of such venerable names as General Motors (GM) and Citi (C) trading at low to mid single-digits, it’s no wonder we are seeing huge jumps in daily swings.

Comments

[jzamoras:]

Brilliant!

2008 Nov 26 12:10 PM

[William Samedy:]

Volatility clustering is an issue Mandelbrot treated widely. www.leveragedinsight.c...
And that explains much of why we’ve seen that big moves on the up side or down side come in groups.

2008 Nov 26 02:07 PM

[Smarty_Pants:]

One other possible contributing factor: if the hedge funds are sitting out, then the markets are much thinner and more likely to move further for any given volume of orders.

2008 Nov 26 02:18 PM

[happysoul77777:]

This is a key factor: the removal of the uptick rule in July 2007. A few weeks after the removal, volatility started to rise.

The removal of the uptick rule gives the sellers the powers to push stocks down fast and hard. Investors are scared, they buy puts. The VIX increases because more people buy puts for protection. The market makers sell puts to investors, they have to sell stocks naked (it's very bad for the market, but they are allowed to do tha!) to hedge their positions. Most of them probably will pile on to make more money. Stocks crash. The VIX goes higher. The cycle keeps repeating. When the market is oversold, many shorts want to cover. All of a sudden, the market pops hard, but the trend is still down and the VIX is still high, sellers come in again and blitz the market, The market tanks.

It's almost a certainty that the market is going to stay volatile until they reinstate the uptick rule.

Statistics show that rising volatility correlates with declining markets. Why? Because uninformed investors sell puts and get margin calls, when their stocks fall through the strike prices. Informed buyers purchase puts. Their purchases make the market makers sell stocks short, adding to the downside pressure and increasing volatility.

Thus you can see that the stock market is structural unsound, because the sellers have too much power.

The SEC must reinstate the uptick rule, otherwise the stock market continues to be a casino but not place for 401K investing or capital formation.

2008 Nov 26 09:37 PM

[DollarTalk:]

I am very thankful for the blessings that I have in my life. Now, regarding the market, the power of optimism never ceases to amaze me. In fact, we are missing a very large component of our view on the market and the economy in larger view when we discount the role of perception. Most of this market volatility was brought on by increased uncertainty and the perception that our credit crisis and financial difficulties were beyond our ability to solve as a free market. This, of course, was exacerbated by the media and capitalized on by the media in order to accomplish the election of now President-elect Obama. Now, the media has their man and would do well to continue to promote positive, uplifting views on the future direction of the economy and the solutions and people proposed by President-elect Obama. Otherwise, they will find themselves in the company of the Republican party when the public develops a pessimistic or negative perception of the new President and his leadership team. That's all for now. More on my blog.

2008 Nov 27 01:55 AM

[John Lounsbury:]

happysoul7777 - - -

Excellent comment. I do agree with your concern about the up-tick rule but I believe the contention that it is the controlling factor in this bear market may not be entirely correct. You said:

"It's almost a certainty that the market is going to stay volatile until they reinstate the uptick rule.

Statistics show that rising volatility correlates with declining markets. Why? Because uninformed investors sell puts and get margin calls, when their stocks fall through the strike prices. Informed buyers purchase puts. Their purchases make the market makers sell stocks short, adding to the downside pressure and increasing volatility.

Thus you can see that the stock market is structural unsound, because the sellers have too much power.

The SEC must reinstate the uptick rule, otherwise the stock market continues to be a casino but not place for 401K investing or capital formation."

My comments:

1. Secular and super cycle bear markets (which we are probably in currently) typically have high volatility, whether an up-tick rule is in place or not.

2. There is no evidence (or logical hypothesis) that the ultimate bottom of a secular bear market can be significantly changed (in price) by the presence or absense of an up-tick rule. These markets have, in the past, bottomed with single digit PE ratios. If this market bottoms with significantly higher PE ratios, there will be a basis for proposing that the lack of an up-tick rule might have contributed to a higher bottom. This proposal would be subject to debate because one sample is not statistically significant. However, it would prove an existence theorem and be the basis for constructing a new market behavior model.

3. It might be argued that the absense of the up-tick rule contributed to more rapidly reaching the bottom. If the bottom of 11/20/2008 holds, this will be the shortest secular bear market in history (since 1900) by nearly 50% (1.0 years compared to the next shortest, 1.9 years for the 1974 bottom).

4. The lack of an up-tick rule cuts both ways. If it in fact contributes to more rapid declines, short-covering will also produce more rapid rises. The end result might be similar valuations. A long-term investor (such as a 401(k) participant) will not be affected by volatility, only by the long-term result.

5. Ultimately, short sellers will be crushed when valuations reach compelling levels (single digit PEs). If the decline turns out to be more rapid, the recovery will also, most probably, be faster. If this turns out to be the case, I would ask the following question: Would you rather be exposed to several gallons of water by being waterboarded or by immersing your head in a water basin and withdrawing it quickly? If you believe the lack of an up-tick rule is contributing more volatility, the above analogy might cause you to recognize that more concentrated pain on the downside can be rewarded with quicker reward on the upside. At the very least, a more rapid decline should be more tolarable to many than the waterboard-like experience of a protracted decline to the same bottom.

The effect of having no up-tick rule is a very complex issue. Many have criticized this policy, but, in my opinion, the analysis has a long way to go before a clear picture emerges.

Thanks again, happysoul7777, for starting this discussion. Maybe some others will add some additional thoughts.

2008 Nov 27 12:08 PM