2/1/2019 Weekly Update Volatility's Nature
by Zach Marsh on Mar 1, 2019
S&P 500 +1.62%
10 Year Treasury +.26%
Weekly Update: Volatility’s Nature
This week we witnessed a sharp pick up in volatility, but it wasn’t in the stock market. The volatility I’m speaking about, as those of us in the Midwest know, is in the weather. Wednesday morning, on my way into work, the air temperature read -20 degrees. This coming Sunday, the predicted high temperature will be 54 degrees. In a matter of four short days we will witness a temperature change of 74 degrees. Imagine for a moment, a day in mid-July where the morning temp was 30 degrees and four days later it was 105. If that seems impossible to imagine that’s because it is.
Volatility, while always lurking, is most observable at extremes. Volatility is present in all things but is more extreme in certain things. Consider the variance of the height of 1000 women standing next to each other, shoulder to shoulder, on a football field. Now consider the variance of 1000 individual’s wealth, standing in the same place, and consider one of those individuals is Jeff Bezos. Wealth distribution is more volatile than the distribution of height. Height is more evenly distributed, while wealth is not. Lest this turns into a political debate, I’ll assure you that the volatile distribution of wealth actually pre-dates capitalism, democracy, or the USA, for that matter—it existed, as well, in Venice in the 1400’s. Volatility is a phenomenon—uncomfortable, yes, unfair, maybe—but a reality, nonetheless.
This phenomenon takes many forms. While some distributions maintain their consistency, like wealth or height, others change over time, like the weather, the flood patterns in the Nile river basin, or the stock market. Weather, for example, has a seasonality to its volatility. Summer, for example, has much lower volatility than winter, by and large. Here in Iowa, the highest recorded July temperature is only 18 degrees above the average high temp for July. In contrast, the lowest recorded February temperature is 40 degrees below the average February low. Furthermore, temperature changes between days are more random and extreme in February than in July—case in point, this week.
The stock market, on the other hand, may have some seasonality to its volatility as well, but more likely its volatility exhibits an opaquer nature, tending cluster during periodic times. The causes and predictive nature of the clustering are debatable, but its nature to cluster is empirically evident. Clustering exists because volatility is an action and a re-action of price movement. The catalyst is the initial cracking of a stable price regime; the actions are the initial sharp sell-offs, and the re-actions are the counter rallies or snap back price movements. Prices, while seemingly randomly distributed, are actually conditional on the previous day’s, week’s, or month’s action. A volatile move one month is typically followed by an extreme move the next month. In December, the S&P 500 was down 9.2%, while last month it was up 7.9%. Elevated volatility is an action and a re-action.
Another area which exhibits a clustering nature of volatility is politics. The rise to power of Adolf Hitler in 1930’s Germany didn’t occur in a vacuum. Hitler’s rise was a re-action—a snap back, per say. World War I was the catalyst, or the breaking of a stable, but delicate European geo-political regime. The Russian Revolution was the initial action, politically. And fascism became a re-action to the fear of communism and to the void of a traditional government structure created by the collapse of monarchical Germany in 1918. Today, globally, we are in the throws of another potential clustering of political volatility. Whereas, in the 1930’s and 1940’s, the United States’ political structure remained largely intact, ignoring the 4 elections won by the same candidate.
Today, it is difficult to say the same thing. Whether Donald Trump’s election is the catalyst, the action, or the re-action is for the history books to decide. The volatility it has set in motion seems worryingly real. With the 2020 election gearing up, the counter action is mobilizing. Talk of 70-90% wealth tax may get dismissed now as political blustering, but remember, extreme moves are the output of volatility. This common theme is playing out, as well, across Europe. How long markets will continue to ignore this looming drama remains anyone’s guess. But should the political volatility continue to play out the markets will eventually take notice.
Thanks for reading,
Zach and Dave
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