IT IS as if share prices were being set by the Grand Old Duke of York. Since Americas main stockmarket indices peaked in January, they seem to have lost a sense of direction. But they have lost none of their sense of drama. The 499-point one-day rise in the Dow Jones Industrial Average on March 16th was merely indicative of a volatility that has become increasingly familiar. And hundred-point single-day moves, often reversing similar changes the day before, have become positively commonplace on Nasdaq, the electronic exchange stuffed with technology shares.
Greater volatility matters for several reasons. It sheds light on what is happening in an economyand in the minds of investors. It makes investing in shares a riskier business. And it has big knock-on effects on the prices of other securities, such as bonds.
The recent rise in volatility should be seen in its historical context. Because stockmarkets have risen so much in recent years, you would expect bigger swings in the points value of the indices. William Schwert, an economist at the Simon School in Rochester, points out that, although a jump of 499 in the Dow was its biggest-ever daily points gain, in percentage terms it would not make the top 35 increases since 1885. Moreover, he says, volatility is rising from historically low levels. With a century-long yardstick, he says, it is not ridiculously high.
That may be so, but volatility has increased fast enough to have some big consequences. For a start, it makes trading much riskier for those brave souls who favour frequent shifts into and out of the market. How sensitive investors are to this increased risk is debatable, though. Many big institutional investors pursue long-term strategies that pay little or no heed to day-to-day movements.
But what of individual investors? Cynics think that individual investors lack the intellectual wherewithal to understand a concept as sophisticated as volatility. But that is not entirely true, according to a new study by William Goetzmann and Massimo Massa, two economists*. They found that one in five of the 91,000 individual investors they studied responded consistently to changes in volatility. Oddly, though, two-thirds of these regarded increased volatility as an opportunity to move into the market.
Financial economists are unsure why volatility ebbs and flows, but they reckon there are three common causes. One is that investors appetite for risk becomes less settled. Another is that there is a lot of contradictory news about: share prices are responding to new information, which might tell a different story from one day to the next. And a third is that investors are increasingly uncertain about the true value of sharesand about different parts of the market.
Certainly, investment banks are devoting less capital to trading,which their shareholders consider risky. This makes markets less liquid and, therefore, probably more volatile. Philip Roth, an analyst at Morgan Stanley Dean Witter, says that institutional investors are also to blame. One possible culprit is the ballooning index-fund industry. To keep their portfolios in line with their weightings, they have to buy shares when prices are rising and sell them when they are falling, amplifying volatility.
So-called value investors are a further cause of instability. Although they profess to invest only in shares that are cheap, many have done so badly with this strategy that they have dipped their toes into investments that they otherwise would not have touched with a bargepole, notably technology stocks. When these falter, they promptly sell, popping their money back into investments with which they feel more comfortable. Such behaviour helps to explain why the tech-heavy Nasdaq and the Dow have so often moved in opposite directions lately.
What of the other two causes? The current high volume of share trading suggests that there is plenty of disagreement and uncertainty about, rather than a lot of contradictory news. News more often moves prices without resulting in much trading volume, when its meaning is relatively clear. Yet now, on average, every share of every company listed on the New York Stock Exchange changes hands at a rate of once a yearcompared with once every three years in 1981, and every six years in 1974.
There are good reasons to be less confident about how to value shares in general, and tech stocks in particular. The macroeconomic outlook is becoming harder to fathom. Worried about overheating (partly as a result of buoyant share prices), the Federal Reserve has been pushing up short-term interest rates. But many investors think that dot.com companies that have been driving overall prices higher will be little affected by rising interest rates since they have few debts. Old-economy firms have lots.
Which is another reason to fret about increased volatility in the stockmarket. There is a close connection between volatility in the overall market and spreads over government bonds that companies must pay for their debt (see chart). Intuitively, this makes sense: greater volatility in the stockmarket may mean that investors are less certain about firms business outlook, and therefore their ability to service their debts.
Last year was a bad one for the corporate-bond market. Defaults were at their highest level since the recession of 1991. The outlook for this year is little better. Lea Carty of Moodys, a rating agency, expects defaults on junk bonds to exceed 6% at an annual rate later this year, compared with a historic average of 3.25%. This greater risk of default is linked to greater stockmarket volatility.
In fact, it is probably more complex than this. KMV, a credit-research firm, looks at the behaviour of a firms share price to assess the likelihood of it defaulting. The firm reckons that the risk of default among the 9,000 or so non-financial American firms it tracks has doubled in the past 18 months. This seems odd. Firms equity is measured at market prices, and their debts at face valueand equity prices have gone up rather a lot in the last 18 months. You would expect default risk to have fallen. So why hasnt it?
One reason is that many firms have increased their debts sharply. In the year to last September, debts of non-financial firms increased by 12%, the fastest rise since the mid-1980s. Much of this has been in the form of short-term debt, which is riskier for firms because lenders might refuse to roll it over.
A lot of the extra debt has been used to buy back shares. This is potentially problematic because investors are left more exposed to the underlying business risk of a firm: they end up with what is left after its debts have been paid. And thanks to the frenetic pace of technological change, that risk may be increasing. The net result, says David Goldman, a credit analyst at Credit Suisse First Boston, is that giant firms with seemingly unassailable market positions are becoming as risky as high-tech companies. And the spreads on their bonds over Treasuries may start to increase, tooas those of lower-grade debt have already done.
Rising volatility may point to even nastier scenarios. Before the stockmarket crashes of 1929 and 1987, it increased sharply. Robert Shiller, author of Irrational Exuberance, a new book on the stockmarket and investor psychology (see article), says that history may not repeat itself: volatility can rise and fall without a crash. On the other hand, it does tend to increase as public interest in the stockmarket increases, and you cant have a crash without a lot of public attention being paid to the market. In America, the publics obsession with shares has never been greater.
*Daily momentum and contrarian behaviour of index fund investors, by William Goetzmann and Massimo Massa, Yale School of Management, December 1999.