Volatility Returns

Includes: DIA, QQQ, SPY, VXX
by: Felix Salmon

Ah, volatility. Suddenly, at 2:30pm this afternoon, the US stock market decided it was going to fall off a cliff, and the Dow promptly proceeded to drop about 700 points in the space of mere minutes, before bouncing back up. This is pure market craziness: if any journalist tries to blame “worries about Greece” or anything like that, ignore them — insofar as there’s a simple explanation, it’s probably something to do with a dodgy feed on Procter & Gamble’s (NYSE:PG) stock price, which fed directly into the Dow, and caused a brief spell of utter panic.

I suspect that this is only the beginning of a new era of volatility. Markets are a bit like volcanoes, or earthquakes: they’re inherently unpredictable, but if they’re quiet for a while, the magnitude of the next big event is likely to be that much bigger. The trigger for this particular move could have been anything; the lesson to learn is that given the complexity of contemporary financial markets, correlations can pop up anywhere, and a relatively small uptick in something like Portugese CDS spreads can combine with a glitch somewhere in the equity markets to get magnified into an event which wipes out hundreds of billions of dollars in capitalization in the blink of an eye. Or maybe it was the UK election, or a butterfly flapping its wings in Kuala Lumpur: there’s no way of ever knowing.

To take a little bit of a step back, Dow 10,000 is something which most people would have thought absolutely wonderful if you’d asked them at any point in the first half of last year: there’s a lot of room to fall. As the world has been releveraging for the past year, equity valuations have been increasingly predicated on the sustainability of a rapidly-growing debt pile. The stock-market collapse of 2008 was a delayed reaction to the credit crunch of 2007, and similarly now we might see equity valuations be marked down as the world of credit becomes very dicey all over again. Alternatively, the incredible rapidity of this afternoon’s rebound might reassure investors that the market is self-correcting and pretty safe.

But that would be the wrong conclusion to draw from this episode, I think. My feeling is that we’re going to have a turbulent journey into a world where risk assets all price off each other in highly complex and unpredictable ways: a radical change from the old world where credit instruments traded at a spread to governments, while stock investors took solace in the low spreads and high liquidity of commercial paper. In the new world, devastating correlations can appear out of nowhere — and then disappear again just as quickly. And anybody who wants to stay in the market is going to need a very strong stomach.