Air Pocket Economy Takes Stocks on a Wild Ride
Life + Money

Air Pocket Economy Takes Stocks on a Wild Ride

Most stock market investors know they should expect a bumpy ride. Stock prices move up and down every day. But this? Since April, stock market volatility has routinely spiked 50 percent to 100 percent above normal levels, often more, and many strategists say there will be no relief until well into 2011.

A 7 percent drop in the Standard & Poor’s 500-stock index in the first week of May kicked off another long and harrowing ride that has whipsawed investors. Consider a 3 percent single-day pop up in the S&P 500 on June 2, followed by a jarring 4 percent decline on June 4. And a 5 percent decline in the index during the week of June 28, followed by a 5.6 percent gain the following week.

The trend abated a bit in July, when volatility eased and the S&P 500 rose 6.9 percent. But don’t be fooled, says Sam Stovall, chief investment officer at Standard & Poor’s. After the second quarter’s nearly 12 percent decline, the market was poised to snap back. Its upward surge isn’t likely to last.

“I did a recent market study that shows after a quarter in which there has been at least a 10 percent decline, the market will surge 70 percent of the time, on average by 4.5 percent in the first month and less than that—an average 1.5 percent—in the second month,” Stovall says. “But the third month is when we slip back downwards.” If history is a guide, he says, investors should brace themselves for a snapback in volatility come September, he says.

The wild swings reflect a deep and lingering uncertainty among investors, about the market and about the economy. “It’s like peeling an onion. The more you peel it back, the more it causes your eyes to water,” says Hans Olsen, chief investment officer at JPMorgan Chase. “There is uncertain tax policy, uncertain regulatory environment, uncertain sovereign risk, uncertainty surrounding who has a balance sheet you can support,” Olsen says.

The latest economic data aren’t encouraging. The Federal Reserve’s Beige Book report on regional economic trends, covering the period from early June through mid-July, showed a slowdown in the growth of consumer spending, the job market and manufacturing activity, and the commercial and residenial real estate markets remain very weak. GDP rose less than expected in the second quarter.

Gyrations in stock prices were even more extreme during the height of the financial crisis between September 2008 and March 2009, when the S&P 500 tumbled 45 percent. For months after that it seemed as though the storm had passed and investors could release their white-knuckled grips on their portfolios.

Investors moved back into the market as they realized they had missed out on what turned out to be an 80 percent gain in the S&P 500 between March 2009 and April this year. But just as they were putting their toes back in the water, concerns about foreign debt problems and signs of sluggishness in the U.S. economy, such as a continued high unemployment rate, escalated. “It’s hard to recall a period where there was so much uncertainty at the policy level,” says Leo Grohowski, chief investment officer at BNY Mellon Wealth Management.

Major stock market indexes are now about where they were at the start of this year. After a 2.2 percent gain on Monday, the S&P 500 pulled back about 0.5 percent on Tuesday, and remains more than 15 percent below its recent highs in late April.

The Chicago Board of Exchange Volatility Index, known as the VIX, measures the market’s outlook for volatility over the next 30 days. The normal range is 18 to 20, from October 2008 to March 2009 it bounced between 40 and 80. Since May of this year, the VIX has been fluctuating between 30 and 45, though lately it pulled back to between 22 and 30. “It has come down, but it will remain at elevated levels for the year,” until the sovereign debt cleanup is under way and confidence has returned in the global economy, says Grohowski.

Low stock market trading volume is another sign of investor uncertainty, and it also contributes to volatility. Fewer than two billion shares have changed hands at the New York Stock Exchange in recent days, compared with an average for the year of more than five billion. As many investors sit on the sidelines, “it’s not taking as much news to drive the markets higher or lower in a more dramatic fashion than is normal,” Grohowski says.

Volatility in general is higher than in previous decades, says Stovall at Standard & Poor’s. “When you compare this market’s volatility to volatility in the ‘60s, ’70s, ‘80s and ‘90s, it has been going up by decade and I wouldn’t be surprised to see that continue,” he says. “Individuals are making numerous intra-day trades and it doesn’t cost as much as it used to, and technology has gotten more sophisticated.”

Speculators practicing  high frequency trading and using advanced technology to execute trades contribute to the rise in volatility. “The market is dominated by speculators as opposed to investors, and that’s a huge change,” says Jonathan Hirtle, CEO at  Hirtle Callaghan Group, a private wealth management firm in Conshohocken, Pa. “This notion of Wall Street being turned into a casino is why volatility is so great.”

Of course, high volatility drives even more speculation. Rapidly fluctuating price changes present numerous and fleeting opportunities for speculators to execute rapid-fire trades and lock in gains. “Speeds have broken the millisecond barrier,” says Anshuman Jaswal, a senior analyst at Celent, a financial services consulting and research firm. “The number of orders and positions taken have increased dramatically on any given trading day.”

One of the best examples of the impact of technology on the speed of the market movements was the  Dow Jones Industrial Average’s 985-point intra-day drop in early May—a record-breaking plunge. “That flash crash scared a lot of traditional and smaller investors who say, ‘I can accept above normal volatility, but I can’t accept a 1,000-point dislocation in the Dow without an adequate explanation as to what caused it,’” says BNY Mellon’s Grohowski.

Beyond the fear factor, investors have good reason to hope for calmer times. Volatility has historically had an inverse relationship with returns. When volatility is high, the stock market idles; when it eases, prices rise. Jeffrey Applegate, chief investment officer at  Morgan Stanley Smith Barney, says that looking at peaks in volatility, the subsequent return on stocks “is always positive and usually pretty handsome.”