Curious Episodes That Bode Who Knows What

The volatility we have seen in financial markets since the middle of July will go down, I suspect, as a good case study in future years for connoisseurs of curious episodes in market history. While years of experience caution us all against describing the market as having lost touch with reality, the past six weeks may come to merit just such a description. Salute the wisdom of crowds, by all means, but wisdom is precisely what seemed to go walkabout as soon as the big beasts in the investment community and government packed their bags and went (or tried to go) on holiday in mid-July.

The daily volatility in the last few weeks in the stock market has been extraordinary to observe, for anyone who inadvertently happened to remain sitting in front of a screen during the whole of the period. At its worst, over just four days in the second week of August, US stocks, as measured by the NYSE composite index, recorded a succession of dramatic daily moves: minus 7.0%; plus 5.2%; minus 4.4%; and then plus 4.6%. The average daily movement over the past 15 years is around 0.8%.

And these were just the changes from one close to the next. The intra-day movements were even more extreme. It is a notable event when more than 90% of the stocks on the New York Stock Exchange to move in the same direction on a single day. Yet in quick succession we experienced not one but four successive days (two up, two down) in which 90% of the stocks listed on the New York Stock Exchange moved either up or down in virtual unison.

While there have been many bigger single day movements, according to Lowry’s Research there has never been anything quite as frenzied as this four-day period in its 73-year history of collecting data. The two down days rank in the top 25 all-time list of largest percentage changes in the S&P 500 index. August 8th 2011 comes in at number ten, behind four days during the height of the post Lehman Brothers crisis in 2008. Volatility that day, as measured by the VIX, reached its highest point since the crisis.

Such violent swings are unusual, but what, if anything, do they tell us? Less than you might think, I suspect. It is clearly not difficult to rationalise why stock markets should have fallen and government bond prices (to the continued bemusement of many) have risen. The Eurozone crisis, the debt ceiling debate in the United States and the mounting evidence of slower-than-expected economic growth are the obvious culprits. But these are, in general, large, global, systemic problems which cannot – and will not – in practice be resolved in a matter of days or weeks.

Thus while the 11th hour debt ceiling agreement in the American Congress certainly had symbolic value, the critical decisions about where the reductions will fall have been left to a divided special Congressional committee to resolve.  Similarly the positive way that the markets initially reacted to the Sarkozy-Merkel euro summit meeting in July very quickly (and rightly) gave way to a more sober assessment of whether (and how) in fact the necessary debt reduction measures will be implemented in the worst affected Eurozone member countries.

The whole point about the issue of sovereign debt, and indeed the banking crisis which preceded it, is that finding a resolution is certain to be a long and drawn out process, for which there is no magic wand solution, and no certain path to resolution. Investors crave certainty, but who, hand on heart, can say that the (in my view, very real) risk of Eurozone fragmentation or collapse is greater today than it was, say, four weeks ago? Even if you believe that the stock market has predictive power – and it is a proven leading indicator, but one which unfortunately misses as much as it gets right – it is hard to read a coherent pattern of thought into its extraordinary gyrations in the last month.

Tempting though it is to ascribe the dramas of August to a violent change in the global economic and political environment, internal market dynamics have probably had just as a big part to play.  Enforced deleveraging by hedge funds caught the wrong side of a thin market was one such factor.  A sizeable proportion of trading was originated electronically, continuing a remorseless recent trend. While computer-generated algorithms may be well placed to profit from marginal inefficiencies in security prices, they by definition make for lousy soothsayers.

A more fundamental interpretation of the market’s erratic behaviour may simply be that risk-averse investors are struggling to chart a course through an environment in which historic parameters and assumptions are no longer valid. This year’s summer volatility, rather like last year’s, I suspect, does not in fact tell us much about how or when the Eurozone crisis is going to end, only that it is likely to end badly.  The only comfort is that the worst bear markets tend not to start in such a violent fashion – they tend to be more drawn out affairs – and peaks in volatility invariably turn out to create useful trading opportunities.