Close your eyes and try to remember the roughest, bumpiest road you’ve ever traversed (in my case, it’s a close race between four-wheeling experiences in East Africa and Southern Mexico). Now imagine the scariest, rickety, wooden roller coaster you’ve ever seen. What would it be like if the roller coaster were mounted on the bumpy road? Go one step further. As you rattle and plunge along on this contraption, you’re not safely strapped in a padded seat. Instead, you are astraddle the meanest bull that ever entered a rodeo arena. Got the picture? That’s roughly what it was like on the stock market over the past week.
Some days the market collapsed; other days it rose at near record rates. The amazing thing was not the magnitude of the swings, dramatic though they were. The shock was the volatility from the opening bell to the banging of the gavel. Multiple swings of several hundred points in a single day were commonplace; in fact, they often happened in a matter of minutes. On Tuesday, I said to a colleague that I had not seen this much movement since the wild gyrations in 1987. Sure enough, when the day was over, the Volatility Index reached the highest level since that time. The fluctuations were far more radical than those observed when the markets reopened after September 11. The situation even has the Fed talking about lower interest rates despite definitive signs of economic growth.
The Volatility Index is a decent and very widely followed measure of swings in the market. It is calculated based on patterns in options trading in securities that track the overall market. It has only been around since 1993, but nerds like me can calculate it further back in time. The technical aspects of this measure, however, are much less important than one simple question—Why?
Since we haven’t dealt with a situation quite like this one before, all I can do is give you my opinion. As a general proposition, there is nothing inherently wrong with volatility. In fact, as markets improve their efficiency and process larger quantities of information more rapidly, volatility is an expected outcome that actually enhances profit opportunities. That is a basic law of markets (and mathematics and thermodynamics, for that matter).
The current market behavior, however, is different. With a general pattern of recovery and almost 90% of firms meeting or beating their earnings estimates, there is no rational reason for such widespread swings in value. It is simply not the case for cumulative future prospects of leading American firms, which is what the market should reflect, go up or down 5% in a single day when nothing extraordinary happens.
That the difficulty stems from the current credibility crisis goes without saying. The larger and more perplexing issue is the nature of the mechanism that causes it to happen. First of all, it doesn’t matter if a high percentage of companies make their numbers if nobody believes them. Academic studies have shown for years that even the best of markets tend to overreact to short-term information. At present, however, the very structure of the system is at issue. Without the basic underpinnings that we normally take for granted, the process that invisibly reconciles supply and demand no longer works. In effect, investors are set adrift.
When this phenomenon occurs, mass psychology replaces orderly market clearing. Overreactions become chronic, leading to selling frenzies followed by buying frenzies. Volumes accelerate to record levels (which they have), and the persistent tendency to exaggerate the importance of the latest bit of information is blown completely out of proportion. Even good news is at times greeted with negative reactions, as a firm in the spotlight for any reason is a potential target of the fickle and uncertain masses.
We have begun the process of rising confidence, but we are not yet there. We can take some solace in the fact that “this, too, shall pass,” from sheer exhaustion if nothing else.