Macro Tsimmis

intelligently hedged investment

Market to investors: “Be cool, man…everything’s copacetic!”

Posted by intelledgement on Wed, 07 Apr 10

Real estate valuation and foreclosure shoes may still be dropping, the deficits may still be growing, credit may still be tight, and the PIIGS may be oinking louder than ever…but the market is telling us that the immediate danger of a 1930s-like meltdown has passed.

We have been tracking market volatility for a while now because it is a reasonably reliable gauge of risk. 80% of the time from 1950 to 2010, when volatility in the S&P 500 goes up—that is, the average daily change in the price of the index (up or down) is greater than it was in the prior year—market performance declines. And when volatility declines year-over-year, market performance improves 63% of the time.

Well, the results are in from 1Q10, and following an epic surge in volatility in 2008 to the highest levels ever, the tide has consistently receded. 1Q10 was the fifth consecutive quarter in which volatility has declined. And the level of volatility in the quarter was all the way down to average: just a ±0.59% daily change in the value of the S&P 500 index. This was the lowest reading in two-and-a-half years…since 2Q07—right before things started getting interesting—when volatility was ±0.44%. Here is a chart showing annual volatility levels for the past 60 years:

Note that the value for 2010 is preliminary, based on just 1Q10 data.

Normally we prefer to use the S&P 500 index for analysis in preference to the Dow Jones Industrial Average because it has a more robust data set: 500 stocks as opposed to just 30. In this case, however, the DJIA has one thing the S&P 500 lacks—historical data prior to 1950. Thus, when it comes to comparing 2008 with 1929, it’s the DJIA that carries the load.

There is a lot of debate about the validity of comparing these two crashes. Bears tend to point to the faltering economies, failing banks and businesses, high unemployment, foreclosures, deflationary pressures—and, of course, the peaks in volatility—as similarities. Bulls tend to brush these aside with the observation that the 1929 crash ushered in a catastrophic depression—the market decline in 1930 was twice as bad as 1929 and 1931 was again worse still—while 2008 was followed by a mere recession (albeit a really bad one) and the market was up in 2009 and is up again (so far) in 2010. Here is chart that compares market volatility for the two crashes:

Following the 1929 crash, there was one quarter of eerie calm, followed by years of “may you live in interesting times.” This time, however, we have calmed down more slowly, but inexorably back to normal volatility. Insofar as this reflects the collective wisdom of market participants, that appears to be that the crash of 2008 is not “the big one” in the same sense that the crash of 1929 was.

This isn’t to say that the common wisdom—that risk here has been reduced—is the be-all and the end-all. Anyhow, given that it more likely fear which engenders volatility than the other way round, using a measurement of volatility as a predictive mechanism would be, well, risky at best.

Be that as it may, while the market could be wrong here—and a lot of minds could change in a hurry should Toto pull the curtain aside—for now reality is that the market perception is, essentially, “Be cool, man…everything’s copacetic!”

Previous volatility-related articles:

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