Try To Remember

September 30, 2011

It has been quite a while since my last update, Gentle Readers.  August and September decided to throw just a few curveballs at the financial markets, so my capacity for what I call ‘discretionary thought’ has been rather limited.

I’d imagine that the market’s daily gyrations mean little to people outside the investment profession – as, generally, they should.  As I’ve mentioned before, it partially amuses and partially saddens me to hear the portentous tones in which talking heads typically describe a daily rise or fall in the Dow of an essentially insignificant magnitude.  A claim such as: “the market was down ~0.5% today on renewed economic concerns” has about the same information content as: “Candidate X leads Candidate Y in polls by 2%.”  Political pundits typically have the decency to note the margin of error of polls that they cite, although they may not stop from drawing conclusions that are unjustifiable in light of it.  Financial pundits, by contrast, rarely contextualize the day’s movements in the market.  There isn’t always an explanation for why a market index fluctuates by a modest degree.  Sometimes there are just more buyers than sellers, and sometimes there are more sellers than buyers.  That’s it.

How would I better contextualize daily changes in the stock market?  Thanks to the wonders of the Bloomberg Professional data service, it takes me approximately three seconds to pull the daily percentage change in the S&P 500 for the last thirty years.  The average daily change, between 1/2/1981 and 9/30/2011, is 0.03%.  Three basis points!  The standard deviation, however, is 1.15%.  Let’s put to one side the question of whether or not daily stock market returns follow a statistically normal distribution and assume that this is a fair approximation, except for the issue of “fat tails” (i.e., events that in fact happen more frequently than “never in a million years,” notwithstanding the claims of statistics).  The implication is that we should generally be unmoved by daily changes of +/- 1%, and should throw pies at anyone who claims that these fluctuations are necessarily driven by some Big Economic Theme.

But when market indices fluctuate by several percentage points each day, it’s a bit more momentous.  It also used to be relatively rare.  Let’s define as “noteworthy” a daily change of +/- 2.3% in the S&P 500 index.  This represents about two standard deviations of difference from the average.  We’d expect to see moves of this magnitude only about 5% of the time, i.e., relatively infrequently.  In my analysis of 7,760 trading days, there are movements of this magnitude on 360 of them (4.6%).  So it seems reasonable to pay attention to them.

What’s remarkable to me is how these 360 “noteworthy” days are distributed over time.  We might naively assume that, over 30 years, there would be about 12 per year, or one per month.  But the market doesn’t work that way – volatility tends to beget volatility.  These noteworthy days are in fact quite concentrated.  There were 29 of them in 1987, but only three in total during the calmer years of 1992-1996.  There was another spike in 1998, related to the Russian debt crisis, and another in 2000-2002 related to the dot-com boom and bust.  There were zero noteworthy days from 2004-2006.  Ah, that happy, golden, bygone era.

Consider this: in 2008, there were 63 noteworthy days, of which 46 occurred in the final four months of the year.  This is not news to anyone who lived through those dark days, but it is staggering when considered in historical context of what ‘ordinary’ volatility should look like.

The market remains at an elevated level of volatility, having notched 17 noteworthy days through the end of the third quarter of this year.  The S&P 500 has lost just over 12% of its value since the end of July, which will certainly shock some people when they see their next 401(k) statement balance.

I tend to think that Wall Street, like a college extra-curricular group, has an institutional memory of no more than four years, so I suspect we’re approaching a phase where professional investors will become to some degree desensitized to historically ‘extraordinary’ volatility.  I don’t have a good guess as to what the implications will be.

Hold on to your hats!