The vicious stock-market decline of the past week has sent volatility gauges soaring. People are now following every twitch of the VIX index – a measure of expected market turbulence – the way they once tracked hot stocks or cryptocurrencies.
The VIX has doubled since its levels in late January and may signal more trouble ahead for stocks. In Toronto, the S&P/TSX Composite declined 3 per cent this week, while U.S. stocks suffered one of their worst patches since the financial crisis, despite clawing back some of their losses in a wild, back-and-forth day of trading on Friday.
But the outburst of volatility also highlights a less well-known phenomenon: how small shifts in expectations can translate into big market moves, especially when stocks are as expensive as they are now.
This can result in market mayhem that appears to come out of nowhere, for no particular reason.
Keep in mind it wasn't bad news that triggered the recent selloff. Instead, the catalyst was a jolt of good news.
Specifically a report on Feb. 2 that revealed surprisingly strong wage growth in the United States.
Traders immediately began to worry about the higher interest rates that would result from this evidence of a stronger economy. Their concerns were entirely valid. Higher interest rates and bond yields will make fixed-income investments more attractive and create more competition for stocks.
But there is also a positive side to this story. Higher wages mean people will have more money to spend on goods and services. If higher interest rates are the direct result of stronger expectations for economic growth, the overall pain for stocks from higher rates may not be as severe as many fear.
The dividend-discount model for pricing stocks – a model that gets taught in every first-year finance class – emphasizes that what really matters is the gap between the rate of return an investor expects to receive from a stock and the projected growth rate of its dividends.
The model shows that stock prices are exquisitely sensitive to minor changes in assumptions. If an investor's expected return or predicted growth rate moves even fractionally, the result can be neck-snapping changes in projected prices.
In the current U.S. market, a rise of half a percentage point in expected growth rates would make stocks 25-per-cent more valuable, according to John Cochrane, an economist at the Hoover Institution at Stanford University. Conversely, a half-percentage-point rise in real interest rates would knock almost 17 per cent off the market's value.
"No wonder stocks are (usually) volatile!" Dr. Cochrane writes. (He provides more detail about his calculations on his blog, The Grumpy Economist, at johncochrane.blogspot.com.)
The real surprise, he notes, isn't the market's current volatility, but its conspicuous lack of volatility in preceding years. This long period of unusual stability lured many people into betting the calm would persist. Typically, these folks "shorted," or sold, the VIX index as a way to bet against volatility. They are now paying a horrible price.
Still, it's difficult to turn their personal disaster into a tale of market calamity ahead. As Dr. Cochrane notes, the folks who shorted volatility have lost a lot of money, but those who went "long" on volatility, wagering that market turbulence would reappear, have just gained an amount equal to what the shorts surrendered. For the market as a whole, life goes on.
One lesson we should all take from this is that betting on volatility, or the lack thereof, is profoundly dangerous.
Another lesson is that high volatility is likely to continue. Traders are rushing to adjust stock prices to reflect new assumptions about growth and rates. Given the swirling questions around central bank policy, trade agreements and U.S. tax reform, the outcome of their adjustments is still highly uncertain. Even minor changes in assumptions could send stock prices rocketing up or down.
The one thing that is certain is that you can do a lot to manage the amount of volatility in your portfolio. Start by asking yourself: How would I feel if the market suddenly plunged 35 per cent? That is the typical loss for stocks in a bear market, notes Jonathan Clements, the personal finance expert behind the humbledollar.com blog.
If a loss of that magnitude would devastate you, it's time to adjust your holdings. Shifting to a portfolio of half stocks and half bonds would mean a typical bear market loss would carve only a 17.5-per-cent hole in your overall portfolio. This would be painful, but not disastrous, especially since the fall in stock prices would prime them for better gains in the years ahead.
As always, it's a matter of managing what you can manage. And, of course, holding on for the long term.