What’s Behind Recent Stock Market Volatility?

January 15, 2009

General George Patton once said, "If everyone is thinking alike, then no one is thinking." That seems to be what is happening today as the stock market careens higher like a mad roller coaster only to suddenly drop in a steep descent.

General George Patton once said, “If everyone is thinking alike, then no one is thinking.” That seems to be what is happening today as the stock market careens higher like a mad roller coaster only to suddenly drop in a steep descent. We are going through a period of significant market volatility which in less than a day can carry you to a pinnacle of exuberance only to drop you into a pit of depression by end of the trading day.

Compare the present volatility to the period between the end of 2003 and 2006, in which there were only 2 days where there were market moves of more than 2%. Recently, the

S&P 500 has shot up or spiraled downward at least 4 % in just one day! Moves of 1% in the S&P 500 on a daily basis have become ho-hum. This is a perfect example of why the market is an Auction Market, attempting to find value. When fundamental metrics are difficult to read, the market swings become greater as the market continually tries to find value. That is why you hear the pundits describe an Auction Market, without really knowing its process in the market right now, and not knowing what value really is.

Precipitous drops in the market have been followed by sharp rallies, and it’s difficult to tell just what made it all happen. Some of the downward moves have trailed bad economic news, but at other times, it is difficult to determine just what set off the downward spiral. Volatility is not an indicator that the market is in good health, and it is usually symptomatic of increasing distribution by hedge funds and other large institutions that are forced to liquidate as their dissatisfied investors cash in.

Just as wide swings on the vital signs chart indicate instability in your patient’s condition, ups and downs in the market are symptoms of problems. Extreme market volatility is a sign that it is in severe distress and attempting to find value.

In 1987, the market went through similar wild gyrations, but the structure of the trading mechanism was very different 2 decades ago. There were delays in the trading system; traders in Chicago did not know what was happening in real time in New York. Coordination between the equity markets was poor. On Black Monday, Oct. 19, 1987, the Dow fell almost 23% and the S&P 500 dropped 20%. NASDAQ brokers simply stopped answering the phone—effectively halting trading, so that index only descended 11%. The NYSE and commodities markets shut down as liquidity dried up. Then, programmed trading kicked in, making the problems even worse.

Haim Mendelson, professor at Stanford’s Graduate School of Business, has spent over 25 years studying how liquidity in the securities markets affects stock prices. He says “Research from 1987 shows that there is a strong correlation between the loss of liquidity across stocks and decline in price. When the loss in liquidity is dramatic, decline in prices is dramatic.”

After 1987, improved trading mechanisms were implemented, and now everyone has access to the same minute-by-minute information. Circuit breakers were put into effect to halt trading in a specific stock, or the entire market, if the swing was too great. The goal was to get people on the other side of trades and bring liquidity back to the markets.

Today’s increased volatility is due to the speed of information about stock prices and a fundamental uncertainty about the economy.

Experts predict that volatility will be with us until we are out of the economic woods. Economist Benjamin Graham once said, “Most of the time, stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble …to give way to hope, fear, and greed.”

Michael Doran is Managing Director of the long/short equity fund, Emerald Bay Partners LP.

Mr. Doran can be reached at (530) 677-1635 or sierracap@directcon.net.

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