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Question of the Week - September 14, 2015

Question of the Week - September 14, 2015

Guest Post - Monday, September 14, 2015

Volatility has sure picked up. What’s the best way to think of volitility?

Even with the recent correction aside, this type of volatility is actually much more normal than the opposite condition of low volatility. Since the 1950’s (when the S&P 500 was created), absolute daily changes in the S&P 500 amounted to about +/- 0.7% per day. Interestingly, if we take this back further to the inception of the DJIA in 1896, daily changes are a remarkably similar +/- 0.75%. Markets and trading technology have no doubt changed, but these provide interesting behavioral benchmarks for what ‘normal’ expectations might look like. So, 1% up or down days aren’t really that strange after all. Since the standard deviation of those daily changes is just short of 1% as well, even a band twice as wide as the ‘normal’ daily move isn’t overly unusual historically.

What we’ve grown accustomed to in recent months is a low volatility environment, which for equities, has never been realistic over the long-term. Since the early 1990’s, we’ve had the VIX index to capture this effect somewhat, which prices the implied volatility of equity markets as an output of formulas used to price stock options. While useful, it’s also interestingly pessimistic, as the VIX has perpetually tended to show a higher risk level than what has been experienced (if measured by trailing months of market activity). This plays into the ‘stocks climb a wall of worry’ maxim, in that the future is always assumed to be more volatile than the recent past. That’s probably a good thing to keep animal spirits in check.

Seasonally, we see other factors that add to volatility. It’s cliché to say that markets pick up in volume right after Labor Day as traders have returned from the Hamptons, but there is some truth to it—it’s also the case in Europe, if not more so, as the entire month of August is assumed to be a continental-wide vacation. Starting about now, the current year starts to be written-off while hopes for 2016 become the next target of analyst focus. As opposing bullish and bearish forces jockey for information to support their views, uncertainty in determining ‘fair values’, i.e. daily price volatility, is the natural result.

Of course, from a macro level, there is always something to worry about. Which factors are most meaningful and take the highest importance on a given day will vary. A few years ago, volatility was about a potential meltdown of the entire global financial system. Today, it’s Fed policy as well as a slowing of the Chinese economy. Importance is a matter of context, and the magnitude of market volatility generally follows the path of severity. Areas of less transparency also add to volatility, and despite China’s girth and status as one of the world’s largest economy’s, no one really knows with precision how large that economy actually is or what growth rates really are (savvier analysts have derived best estimates through back-door approaches like energy usage, etc. but government data is viewed with skepticism by many). Any market opaqueness leads to differing hypotheses about final effects, which leads to uncertainty over fair values, which leads to volatility.

So, there is nothing new here, although we realize it’s difficult to see out of the fog and the media’s persistent focus on the negative. However, while this is a historically volatile time of year, it’s traditionally been a rewarding one for those staying invested as well.

Additional Reading

Read our Weekly Review for September 14, 2015.

Read the previous Question of the Week for August 24, 2015.

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