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Expect More Huge Daily Market Swings

As I write this on November 26, the S&P 500 Index is down by about 4.6% for the week. The S&P 500 dropped 1.9% on November 21st and then dropped 2.2% on November 23rd. These are enormous daily drops. 

Something has happened that has convinced the aggregate of market participants that the total value of every company represented in these indexes is suddenly worth about 4.6% less today than they were worth a week ago.  What terrible news has led to this reduction in the value of these hundreds of firms? 

Nothing concrete, really. 

Sure, the news sounds bad and there is no immediate resolution on the future of the Eurozone economies. Or maybe it’s just that the days are getting shorter and many people are gripped with seasonal depression.  Who knows?  The real issue for most of us, however, is not understanding why this is happening, but rather to think through the implications of this volatile market. 

The first thing to be aware of is that the levels of volatility that we are experiencing today should not be considered out-of-the blue.  Back in mid-September, I noted that the market was telling us that we should expect high volatility for the foreseeable future. Specifically, the prices of options on the S&P 500 were telling us to expect annualized volatility of 32% through March 2012.  We can convert annualized volatility to daily volatility by dividing by 15.87 (this is the square root of the number of trading days in a year, 252).  When we divide 32% by 15.87, we get an expected daily volatility of 2.02%.  This daily volatility is an estimate of what a normal daily swing in the market will look like.  In simple terms, we can expect about 2/3 of individual days to provide returns that fall between +2.02% and -2.02%, but we should also expect that one-out-of-three days will see swings of higher magnitude (in both directions). 

Remember that I am using the market estimate for S&P 500 volatility in mid-September.  When we look at daily returns from September 15 through November 18, the market has followed this projection of daily volatility pretty closely.  Out of the 46 trading days in this period, we would expect that 30-31 of these days would experience a market move of between +2.02% and -2.02% and that 8 of these days would experience a loss worse than -2.02% while 8 of the days would see gains greater than +2.02%.  Over this period, we have seen exactly 8 days with losses of -2.02% and worse, and four days with gains greater than 2.02%.  In other words, in the last couple of months, we have seen daily swings in the S&P 500 that are consistent with what we would expect based on what the market was telling us in September. In addition, the options market is telling us to expect a comparable level of volatility going out into 2014. The annualized implied volatility on put options expiring in January 2014 is right around 30%

So, the market volatility we have experienced recently—with daily swings of around 2%–is consistent with what the options markets predicted back in September.  Furthermore, the current options market data is telling us that this level of volatility is what we can expect for 2012 and 2013.  This level of volatility is considerably higher than the long-term historical average volatility for the market, but there are obviously a range of reasons that might be used to justify why the market is going to remain unstable for the foreseeable future. 

The implications for investors are fairly straightforward. First and foremost, this level of volatility is consistent with market expectations and does not mean that the wheels are coming off.  In other words, the market is very clearly telling investors that this is the ‘new normal’ for stock volatility, at least for the next couple of years.  So, this is kind of a ‘good news / bad news’ scenario.  The good news is that a drop of 2% in a day (or 4.6% in a week) or so does not mean that the smart money believes the end is nigh and is heading for the exits.  The bad news is that we should expect to have to put up with this bi-polar market for the foreseeable future.

The punchline?  Be prepared for a bumpy ride for the rest of 2011 and for the next year or so.

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