What the volatile stock market is trying to tell us
What are stocks telling us? What explains their volatility? Anyone following the market is understandably confused. Over the past century, stocks have usually moved less than 1% in daily trading, up or down.
Of course, there are many exceptions, including the record drop on Oct. 19, 1987, when the Dow Jones Industrial Average plunged a stunning 22.6%. Still, we’re now experiencing something new: routine daily price movements of 1%, 2% and even 5%.
Not only have wild swings multiplied, but they’re also often contradictory. What the market giveth on Tuesday, it taketh away on Wednesday. Up 500 points one day; down 500 the next.
This obviously matters. In 2019, 55% of households owned stock either directly or through retirement accounts, the Gallup poll reports.
In turn, this wealth influences their spending. Lower income and wealth dampen spending; higher income and wealth do the opposite.
At the center of the debate over volatility — those erratic price swings — is the so-called VIX index. (The formal title is the Chicago Board Options Exchange volatility index.) The index embodies investors’ tolerance for risk and reward. Investors in options have the right to buy or sell stocks at designated future prices. How they react to these prices determines the amount of volatility people will accept.
The VIX is often called investors’ “fear gauge,” because the higher the index goes, the greater is the volatility — and the greater the risk or reward for investors. A reading of 12 to 20 on the index generally signifies low daily volatility of about 1%, says Scott Cederburg, a finance professor at the University of Arizona.
News of the coronavirus was devastating. “The VIX index was still quite low in mid-February before the market began to crash,” Cederburg says. “The volatility spike came out of nowhere relative to investor expectations.” On March 16, the VIX hit 82.69, “the highest in the 30-year history of the index.” Although the index has subsided from these lofty levels, it’s still high historically at about 45.
One theory of why stocks are so volatile comes from Alice Bonaime, also a finance professor at the University of Arizona. She argues that, faced with a need to conserve cash, many companies have delayed or eliminated stock buybacks and, in some cases, dividends. This presumably allows share prices to fall further and generates more volatility in the process.
Despite these various theories, it seems likely that they would contribute to a larger cause of increased volatility: economic and political uncertainty.
When investors don’t know what to believe, they tend to believe everything and nothing.
They’re confused and fearful. This makes for higher volatility, as Stanford University economist John Cochrane once argued in a blog post:
“We live in a time of great uncertainty, brought about by great political uncertainty. Great uncertainty leads to volatility. Volatility means that stocks are more risky, and thus must pay a greater expected return to get people to hold them. The only way for the expected future return to rise is for today’s price to go down. So we see a correction … But greater uncertainty means a greater chance that something truly terrible will happen, as well as a chance that it won’t.”
Volatility is a measure of our ignorance, which is why it’s so frustrating and disturbing.