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Volatility in the fourth quarter of 2011 subsided from the scary spike experienced in the third quarter, down 19% quarter-over-quarter. For the 4Q11, the average daily change in the value of the S&P 500 index was ±1.30%, compared with ±1.60% in 2Q11.

We track market volatility because it is a reasonably reliable gauge of risk levels. 74% of the time from 1950 to 2011, when volatility in the S&P 500 goes up-that is, the average annual daily change in the price of the index (up or down) is greater than it was in the prior year - market performance declines. And when volatility declines year-over-year, market performance improves 55% of the time. And 2011 was no exception: for the year, S&P 500 index volatility was ±1.01%, up 37% over 2010's ±0.74%…and market performance declined from +13% in 2010 to flat in 2011.

(Click charts to expand)
Normally, the market is remarkably stable. On average, the S&P 500 index rises or declines 0.62% each day the market is open. Actually, 52% of the time, the change in the value of the index rounds to 0% (that is, the change is less than one-half of one percent). Another 38% of the time, the change rounds to 1%.So the spikes are relatively rare, but when they occur they can be huge. The biggest S&P 500 index spike ever came in 2008. To put the extreme of the volatility in 2008 in perspective, consider that in 60 years of data, there are only three days the market moved ±10%-and two of them were in 2008. There are only 14 days the market moved 7%-to-9% in either direction; six of those were in 2008. And six of the nine 6% days we've experienced since 1950 were in 2008. We did not have a single day like that in either 2011 or 2010. The most recent such day - and the only day like it since 2008 - was a +6.4% gain on October 3, 2009.

After the 2008 crash, many analysts wondered if we were in for a replay of the 1930s depression. 1929 was every bit as extreme for the DJIA (DIA) as 2008 was for the S&P 500 (which itself was not created until after WWII, which is why we rely on the Dow for the 1929 data). Following the 1929 crash, volatility immediately declined sharply from the crash peak to a near-normal level in 1Q30, but then began a jig-jaggy climb that lasted through 1930 and 1931 and into 1932, peaking in 3Q32 at a level (±3.00% on average, every day the market was open!) even higher than 4Q29 had reached. Up until now, the post-2008 pattern has been starkly - and hearteningly - different. Here is chart that compares market volatility for the two crashes:Measured in terms of volatility, the aftermath of the 2008 crash has looked little like post-1929. Prior to 3Q11, post-crash volatility had been steadily declining. We broke below post-1929 volatility levels in 2Q09 and have remained there for the last 11 consecutive quarters, even including the elevated levels of 3Q11 and 4Q11. (In 1932, the average daily change in the DJIA was an all-time record ±2.58% - easily worse than 1929 or 2008 - and while in 2011 average S&P volatility was up 37% year-over-year to ±1.01%, that's a long way south of the red zone.)

Of course, volatility is not predictive. That is, frenetic trading does not generate a black swan event; it's the other way round. Clearly the combination of increased longer-term risk in the USA - highlighted by continuing budget and deficit issues and seeming political deadlock exacerbated by 2012 being an election year - and potential danger of sovereign debt default in Europe with the concomitant systemic risk of large bank failures continue to be challenges. Be that as it may, the most recent USA and Asian macro data on employment, inflation, and growth have been mildly positive, and should politicians in Europe come up with a persuasive solution to the sovereign debt crisis - or even succeed in convincingly kicking the can down the road for a year or two - then the storm clouds could rapidly dissipate and we could be back to boring sunny weather again.

What we can say is that the combined wisdom of USA investors is that the risk, while still at elevated levels, ratcheted down in 4Q11. Stay tuned for further updates.

And in the meantime, if you want to hedge your bets as to how things will play out, you can effectively add the S&P 500 index to your portfolio with the SPDRs (NYSE: SPY) exchange-traded fund, or short it with the ProShares Short S&P500 (NYSE: SH). The DJIA is tracked by the Diamonds Trust (NYSE: DIA) ETF, or can be shorted with the ProShares Short Dow30 (NYSE: DOG) ETF.

Source: Nerve Racking: Q4 2011 Volatility Declines, But Only To Still-Elevated Levels

Additional disclosure: Brad Hessel is a registered investment advisor based in North Carolina; the name of his firm is Intelledgement, LLC. Brad’s clients may be long or short the equities mentioned.