| This week's question is about the recent, extreme market
volatility: "The stock market has been going
crazy this year. How long do you expect this to continue?"
Of course, predictions of this type are always difficult to
state, but I think we will see the high volatility continue for several more weeks, and
then start settling down in June or July. There are statistical and economic reasons for
this prediction.
The Statistical Reason Goes Something like This
We can observe that many things in life tend to be related
over time. Extreme events sometimes linger, such as a dramatic climate change that
persists in a region for a while. However, when it comes to the stock market, extended
periods of extreme volatility do evaporate over time. When the stock market has an
extremely volatile day, by going either up or down by a large percentage, there is a
higher likelihood that the next day will also be volatile (again, in either direction).
Although individuals have probably noticed this for
decades, academic researchers in finance first discovered this phenomenon in the 1980s.
They refer to it as Auto Regressive Conditional Heteroskedasticity. I use this phrase
solely because it increases the average number of syllables per word in my column, which
my editor says makes me look smarter; it also shows how academics often disguise a very
simple idea.
The academic research I'm referring to is: The effect of
market volatility is not as great when you look at month-to-month returns. And, unlike the
relationship between day-to-day volatility, which does increase, there is also no
relationship between the volatility of year-to-year returns, over time.
The possibility of having an extreme month (either positive
or negative) does not increase that much after an extreme month occurs, and the same goes
for year-to-year returns.
We have seen spikes of extreme daily stock-price volatility
many times in the past, and they have always eventually dissipated. Which reminds me of a
traditional piece of advice: This too shall pass.
And the Economic Reasons Volatility Will Soon Settle
Down?
Well first, there is still uncertainty in how much the
Federal Reserve will increase interest rates.
It is almost certain that the Fed will increase rates this
week for the sixth time in a year, which is unprecedented. The Fed increases rates in
order to slow economic growth and reduce the potential for inflation.
However, the unexpected decline in retail sales announced
by the Commerce Department last week is an indicator that the desired slowdown is
occurring. I suspect that this week's interest-rate increase will be either the last or
next-to-last for a while, nonetheless, how much and how long the Fed will go on increasing
interest rates is the uncertainty reflected in the market.
What about Those "Crazy" Internet Stocks?
Market uncertainty over the burgeoning Internet and
computer sectors has contributed to recent volatility. At times, the press might lead us
to believe that this is the first time in history analysts have been required to assess
values for a new and rapidly growing, highly uncertain group of businesses.
However, analysts in the 1980s faced the same problems with
biotech companies, and analysts in the 1970s struggled with electronics firms. There are
novel challenges in understanding all the growth aspects of Internet businesses, but
eventually, the extreme sector movements will settle down, just as the growth spurts of
new industries have in the past.
Economic factors that have contributed to the abnormally
high degree of market fluctuations will eventually erode, and so will the volatility
itself. So, from both an economic and statistical perspective, the craziness will end soon
— but it won't be noticeable at first.
How It Will End
Eventually, we will see a week go by without a 1%
daily change in the Dow or a 2% daily change in the Nasdaq. Then we will see a second
week. The flowers will begin to bloom, the birds will begin to sing, and the editors of
business sections will have to come up with more creative headlines than "Wall Street
Whiplash."
 Lummer's
Logic Archives
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