Volatility Increases Significantly in 2008 Compared to 2007

Worldwide financial markets finished mixed last week with interest rate sensitive sectors (financials, REITs) rallying on the FOMC’s surprise rate cut.

Monday started with a dramatic overseas sell-off as international markets declined on spreading fears that a U.S. recession would negatively impact global economic growth. U.S. markets avoided Monday’s move down since they were closed in recognition of Martin Luther King, Jr.

As U.S. investors braced for a large decline on Tuesday after another harried night of overseas trading (Dow futures were down nearly 500 points in premarket activity), the Federal Reserve stunned market participants with a 75 basis point interest rate cut. This move caught investors off-guard since it came a week before the FOMC’s scheduled two day meeting on January 29th-30th. The magnitude of the rate cut was also noteworthy as it was the largest federal funds rate cut in over 20 years.

Following five straight down days, U.S. stocks finally reversed course on Wednesday. After a 300 point drop, the Dow Jones Industrials roared back in afternoon trading. The index closed the day with a gain of nearly 300 points. The catalyst for the rally turned out to be news that the troubled bond insurers might benefit from a proposed rescue plan led by the New York insurance regulators.

Investors experienced an increase in volatility in 2007 and this “trend-up” in volatility has continued in 2008. Last year, out of 251 trading days, there were a total of 78 days (roughly 30%) where the Dow Jones Industrial Average closed up or down over 100 points. So far in 2008, 12 of 16 trading sessions (75%) have seen triple digit moves! Increased volatility has historically benefited active managers. Additionally, increased volatility provides rebalancing opportunities at the asset allocation level.