What’s causing the big drop in the stock market, and the bout of enormous volatility we’re seeing at the end of the year?
The biggest worry is that this is The Beginning of The End — a recession is on its way, with a consequent big stock market rout. Is this early 2008 all over again, a signal of the big drop to come?
Maybe. But maybe not. Maybe it’s 2010, 2011, 2016, or the greatest of all, 1987. “The stock market forecast 9 of the last 5 recessions,” Paul Samuelson once said, and rightly. The stock market does fall in recessions, but it also corrects occasionally during expansions. Each of these drops was accompanied by similar bouts of volatility. Each is likely a period in which people worried about a recession or crash to come, but in the end it did not come.
Still, is this at last the time? A few guideposts are handy.
There is no momentum in index returns. None. A few bad months, or days, of stock returns are exactly as likely to be continued as to be reversed. The fact is well established, and the reason is simple: If one could tell reliably that stocks would fall next month, we would all try to sell, and the market would fall instantly to that level.
Twenty percent volatility is normal. Twenty percent volatility on top of a 5 percent average return, means that every other year is likely to see a 15 percent drop.
Big market declines come with a recession, as in 2008. But recessions are almost as hard to forecast as stock prices, and for much the same reason.
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They asked me to hold off a few weeks before posting the whole thing. So either wait two weeks or head over to The Hill. I also wrote here "The Jitters" related thoughts about the spring 2018 bout of volatility.
Volatility is the beast risk managers and investors try to corral. It's difficult if not impossible as variance is often undefined. The left tail of the returns distribution is power-law that is between Pareto and sub-exponential. When the tail index, alpha, is less than 2 variance is undefined. In order to define loses, derivatives and inverse market ETF's are used in varying ratios. It seems money managers in their fiduciary duties should be informing investors of these strategies that can limit volatility and potential loss of wealth. For those interested, I develop this in my SSRN paper, A HEDGED PORTFOLIO RISK MANAGER'S OBSERVATIONS AND PRACTICAL APPLICATIONS. Key word, David Seltzer.
ReplyDeleteAre you dismissing the momentum anomaly completely, also at the single stock level?
ReplyDeleteNo. I said "index" for a reason.
DeleteTrue, but the short explanation you give for why momentum should not work at the index level could easily be made at the single stock level: what would be wrong in saying that: "if one could tell reliably that a single stock would fall next month, we would all try to sell that stock, and the price of that stock would fall instantly to that level". Your argument would suggest that momentum should never work, for indices and single stocks.
DeleteI looked at the S&P 500 since 1950. It averaged being down 10% from the previous all time high. The current draw down is within the normal ebbs and flows of the market.
ReplyDeleteGiven the number of people who accused the Fed of inflating a stock market bubble, there should be more rejoicing congratulating Powell for deflating the bubble in such a (relatively) orderly fashion. :-)