E-piphany

The one constant recently has been volatility.

Volatility can be a symptom of a number of different ‘diseases,’ and it is often hard to tell which malady is affecting the market at a given time:

1. Volatility can be a consequence of a paucity of liquidity, so that even light flows can overwhelm the capacity of market-makers to sustain orderly bid/offer spreads. This was one inevitable consequence of the war Congress declared on Wall Street a couple of years ago. By blocking banks’ ability to take risks with their own capital, they also ensured that liquidity would be especially hard to come by when risks rose. The question of whether entities which make bad bets should then be allowed to fail is a separate question (I vote “yes”), but it is clear that limiting dealers’ ability to position speculatively has a long-run affect on bid/offer depth and consequently on liquidity. I’ve been writing about this destructive aspect of the Volcker Rule since it was proposed; see for example here and here.  I don’t know how much of the current volatility is due to this effect, but I suspect at least some of it. Also factoring into this is the fact that when realized volatility rises, the risk management function at Wall Street dealer firms reads it as an increase in the firm’s VaR, and passes down orders for risks to be curtailed to get back within the risk budget. The longer a period of volatility lasts, the bigger this effect tends to be because more and more of the “VaR window” represents volatile market conditions. I suspect that liquidity is at least part of the reason for the recent volatility.
2. Volatility can also be caused when the fundamentals are changing rapidly. Bob Shiller quite a number of years ago (1981) pointed out that this cannot be the main reason for volatility, since the fundamentals just don’t change rapidly enough to explain how much markets fluctuate. It’s known as the excess volatility puzzle. But it is still the case that at times this can be a large contribution to volatility. For example, yesterday the COMEX raised margins for gold futures contracts. Although the news was not released until the close-of-trading Wednesday – after gold had already dropped $162 from its highs over the prior two days, it seems quite likely that some folks knew that a margin increase was on its way – and the prospective increase in margins had a direct impact on the market price of gold. Similarly, the loss of Jobs this week (not Initial Claims; we’ve been losing those jobs for years now, but Steve Jobs) directly impacted the volatility of Apple’s stock and the spontaneous generosity of Bank of America (in giving a large cumulative preferred coupon to Warren Buffet to raise money that it insists it does not need) affected the volatility of that stock. I have trouble attributing, though, the volatility of the general market to rapid and significant changes in fundamentals. The fundamentals are not changing much. They’ve been bad for a while, and they’re getting worse, but they’re not gettingsuddenly worse.
3. However, when attitudes towards fundamentals change rapidly, this can also cause volatility. And this appears to me to be a primary cause of the recent amplitude of fluctuation. The economy isn’t suddenly rotten; it’s just that more people are noticing that the economy is rotten, and people who were fairly sure it would be improving are changing their minds. The debt limit debate didn’t change any fundamentals, but it did change some attitudes. It woke some people up to the terrible fiscal situation we are in. Europe isn’t suddenly in dire fiscal straits; they’ve been there for a while. But the Greek crisis (which appears to be starting again since collateral appears to be an issue; see the Chart below which shows the Greek 2y going to new high yields at 43%) woke some people up to the fractures in the EU.

Greek 2-year yields do not project confidence in anything except a default.

Any way you slice it, the volatility is not a sign of a healthy market. Now, it is true (and an article of faith in many quarters) that when volatility declines again it tends to be good news for prices. But unless you know when that is going to happen, it isn’t a particularly useful factoid – buying into high-volatility markets will occasionally get you long at the right time, but also will occasionally get you FlashCrashed, or in a 1987 debacle, or carried out in some other fashion. I always point out at these times the (quite good, I think) article I wrote a while back on the question of sizing trading bets in crisis situations. In that article I said (in the context of the 2008 crisis), for example:

The relevance here is as follows: when a crisis hits, two things are happening to you as an equity investor. First, you are becoming more confident that the market will reward you for buying when everyone else is selling, because (as noted above) unless the world actually does end you are likely to be getting a good price. Second, though, you need to recognize that the increasing chance of debacle implies a worse payoff. In April of 2008, the chances of losing everything the next day were pretty slim. In mid-September 2008, the chances were appreciable that a bunch of your portfolio might be in trouble. So your edge (confidence in winning, if the bet was repeated a bunch of times) was growing, but your odds (payoff if you win, relative to your loss if you don’t) were worsening.

When prices fall, it improves your odds, but volatility impacts your edge. Keep this in mind as we move forward.

And move forward, we shall. On Friday there is a revision to GDP, and a revision to the Michigan Confidence figure; the importance of these releases completely pales beside the fact that Chairman Bernanke speaks at Jackson Hole around 10:00ET. I do not think he will say anything that will be particularly helpful to equity markets – and I anticipate that stocks will trade lower again. Incidentally, ECB President Trichet is speaking on Saturday; for my money, that is much more important and more likely to produce something shocking. I would not want many chips on the table into the weekend.