Market Volatility? Get Used to It

If you think you’re queasy now, with all the market volatility we’ve been experiencing in the past few weeks, Merrill Lynch quantitative strategist Savita Subramanian has crunched the numbers and comes to this conclusion: get used to it.

In a recent research noted, Ms. Subramanian writes that the historical relationship between monetary policy and volatility suggests that  the VIX – a measure of market volatility often called the “fear index” - will at least remain high until the end of the year and won’t start to turn until January 2009.  The VIX measures the cost of using options as insurance against stock-market losses. It reached an intraday record of C$59.06 on Wednesday.

The rationale for the relationship between volatility and monetary policy is that volatility is driven by several factors that the yield curve (a function of monetary policy) generally predicts. Ms. Subramanian says these factors include liquidity, cost of capital and risk aversion. A steepening yield curve typically reflects increasing liquidity and a lower cost of capital, which has a dampening effect on volatility, whereas a flattening yield curve typically reflects decreasing volatility and higher cost of capital, which amplifies volatility.

With the increase in volatility, the spread between the best and worst performing stocks has dramatically widened, the Merrill strategist says. With this opportunity comes risk. “Being on he wrong side of the trade now costs more than it previously did,” Ms. Subramanian says. Among the implications of her modeling of volatility, Ms. Subramanian says that deep value investing strategies don’t work as well as a GARP [Growth At a Reasonable Price] approach.

Ms. Subramanian said:

Value as a sole factor does not appear to be effective for stock selection. Rising volatility indicates heightened risk aversion – in these environments, investors may become less price sensitive and more inclined to pay for stable earnings growth.