Market Volatility Heats Up in 2Q10... But Should It Be Cause for Concern?

Includes: DIA, DOG, SH, SPY, VXX, VXZ
by: Brad Hessel

All good things — and, presumably, bad things, too — come to an end, and the string of five consecutive quarters with declines in market volatility was decisively consigned to the history books in 2Q10. The average daily change (up or down) in the value of the S&P 500 index spiked 88%, from ±0.59% in 1Q10, which is just about normal, to ±1.11% in 2Q10. Despite this 2Q10 surge, overall volatility in 2010 remains materially below the abnormally high levels of 2009, to say nothing of the all-time record volatility in 2008:

Click charts below to enlarge

We track market volatility because it is a reasonably reliable gauge of risk levels. 80% of the time from 1950 to 2010, 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 63% of the time.

Normally we prefer to use the S&P 500 index for analysis in preference to the Dow Jones Industrial Average because it has a more robust data set with 500 stocks as opposed to just 30. In this case, however, the DJIA has one thing the S&P 500 lacks, which is historical data prior to 1950. Thus, when it comes to comparing 2008-10 with 1929-31, it’s the DJIA that carries the load.

There is a lot of debate about the validity of comparing these two crashes. Bears tend to point to the faltering economies, failing banks and businesses, high unemployment, foreclosures, deflationary pressures — and, of course, the peaks in volatility — as similarities. Bulls tend to brush these aside with the observation that the 1929 crash ushered in a catastrophic depression; the market decline in 1930 (-30%) was almost a repeat of 1929 (-34%) and 1931 (-72%) was more than twice as bad, while 2008 (-38%) was followed by a mere recession (albeit a really bad one) and the market was up in 2009 (+23%) and is only down moderately (so far) in 2010 (-8% as of 30 Jun 10). Here is chart that compares market volatility for the two crashes:

As is evident, measured in terms of volatility, the 2008 crash, apart from the spike, looks less and less like 1929 with each passing quarter. An 88% spike is notable, but never-the-less 2Q10 constituted the fifth consecutive post-crash quarter where present-day volatility was lower — for the last year, substantially so — than it was in the equivalent 1930s quarter.

Despite a panoply of potential black swan events hanging over our heads (the European sovereign debt crisis, the Chinese real estate bubble and concomitant bad bank loans, the interplay of aging populations and structural deficits in the developed nations, the risk of a political, economic, and/or social dispute escalating into disruptive violence, ecological disasters, peak oil, pandemics, sunspots, space invaders, etc.) the collective wisdom of the market appears to be that we have succeeded (at least) in kicking the can down the road. That road had a sinkhole, which looked unsettlingly like the one we came upon in 1929 — and promptly fell into! But this time the market appears to telling us we’ve leaped over the sinkhole, and while we teetered on the far edge for a spell, we have now successfully moved a few steps past it.

True, this is the same market that 15 months ago valued the S&P 500 at 683 and 15 months before that at 1468, but we also have 80 years of pricing data that tell us that we don’t have proximate systemic risk without extremely high volatility levels ... like close to triple the ±1% we experienced in 2Q10.

This is not to say a new chasm couldn’t open up soon, however, right now we don’t see it.

Disclosure: Author is long DOG and SH