Market volatility explained
Investor Daily: Post-1987 reforms ensured the stock markets react in real-time to news, which is magnifying uncertainty about the future.
SAN FRANCISCO (Fortune) -- Let's see, on Monday the Dow was down almost 700 points. Tuesday, it was up 270 and Wednesday up another 172 points. Will the rest of the trading week end higher? Or finish with a nausea-inducing slide?
In some respects, neither will be a surprise. The wild gyrations of the stock market, whether up or down, are written off to "volatility." It's a characteristic of today's equities markets to which we have become accustomed - well, almost. But just referring to "volatility" in the market does nothing to explain why we are seeing such huge swings.
So what does?
In 1987 the stock market went through similar jaw-dropping price swings, a period that is often brought up today. But the structure of the trading mechanisms themselves was vastly different two decades ago, and it was that inefficiency that was to blame for the volatility.
Back then, there were delays in the trading system everywhere. Traders in Chicago didn't know what was happening in New York in real-time. Coordination between equities markets was poor. On Black Monday, Oct. 19, 1987, as the Dow fell almost 23% and the S&P 500 20%, brokers at Nasdaq simply stopped picking up the phone (which essentially halted trading and thus the Nasdaq only fell 11%).
The NYSE shut down, as did the commodities markets. Across all the markets, liquidity dried up as everyone fumbled in the dark, trying to piece together what the hell was happening (and in the meantime programmed trading kicked in, exacerbating the problems).
Haim Mendelson, a professor at Stanford's Graduate School of Business, has spent more than 25 years studying how liquidity in securities markets affects stock prices. "Research from 1987 shows that there is a strong correlation between the loss of liquidity across stocks and decline in price," Mendelson says. "When the loss of liquidity is dramatic, decline in prices is dramatic."
After the meltdown of 1987, the Brady Commission set about fixing the trading mechanisms. Better coordination and connection between equities markets were put in place. Everyone now has access to the same up-to-the-minute information. Nasdaq solved its problems by embracing more electronic trading. Before '87, Nasdaq brokers could run away from their quotes; today that is not possible. The Brady Commission also implemented so-called circuit breakers that halt trading in a stock or the entire market if a swing is too great, in theory, to get people on the other side of the trades and bring liquidity back to markets.
Today's stock markets are transparent, liquid (usually) and highly efficient. So why the volatility now? Mendelson argues that the volatility we now see has two main components. The first is a function of the fixes brought about after 1987 and the speed at which new information moves and gets reflected in stock prices.
"If you look at Monday's announcement that we were officially in a recession, although we kind of felt and knew there was a recession, nobody knew that it had started so early - so it was bad, new information," Mendelson says. "And that bad, new information should drive stock prices down. And in an efficient market it should happen very quickly. The stock market is functioning correctly, unfortunately it's in a direction we don't like."
Whether Monday's news warranted an almost 700 point slide, followed by a 270 point pop the next day, points to the second component of the volatility in today's market: uncertainty. "There is so much fundamental uncertainty about the economy itself, that new information has a big impact on stock prices," Mendelson says. "The way that I look at it is that volatility today reflects new information. You could argue that new information shouldn't have as big an impact, well, OK, so trade against it."
As long as uncertainty remains about the economy, so will the volatility, as jittery investors respond to fresh pieces of news. "Suppose that you could know that this crisis would be resolved in a year or two, and everything would return to normal, then maybe you want to buy a lot of stock," Mendelson says. So why don't you buy now? Because you don't know what's going to happen."
Unlike 1987, there isn't a structural fix that can soothe the stock market; it's working just fine. And trying to stop investors from panicking or even rejoicing at every piece of news is a non-starter. "You can certainly argue that people overreact to new information, but most people would agree that you don't want to regulate people's psychology," Mendelson says laughing.
Volatility is with us for a while, both because it's built in to the market's trading mechanisms, and because we aren't out of the dark economic woods yet. But watching the market for big drops and even big pops is an indication of where things are headed. When Ben Bernanke's pronouncements or the price of oil fails to move markets in big directions, in other words when volatility lessens, it's a sign that the uncertainty about the economy is lessening too. And maybe then, it's time to start buying again.
Looking for guidance in navigating these choppy markets? Let us know what topics you'd like us to cover and we'll try to address your questions in an upcoming Investor Daily. Please note: Fortune cannot give personalized advice on specific investments in your portfolio.