6.9 C
New York
Friday, March 29, 2024

Volatility, the Last Anomaly

Volatility, the Last Anomaly

Courtesy of Tim at The Psy-Fi Blog 

Jitterbugging Markets

Man on pogo stick

As we’ve previously seen many of the strange anomalies that affect investors have a nasty habit of disappearing, just as soon as people recognise that they exist. This wantonly random behaviour gives fuel to the last remaining adherents of the efficient markets hypothesis who can point out that despite the best attempts of behavioural financiers the evidence keeps on vanishing.

Despite the mysterious case of the missing anomalies there’s one that resolutely refuses to go away, squatting in the middle of the markets like a recalcitrant and extremely ugly toad. Rather ungraciously stocks continue to bounce around like a jitterbugger on speed. Regardless of everything else it’s volatility, the last anomaly, that keeps on giving. And then taking away. And then giving back again.

Stuff Happens

Close-up of a young woman wearing a kimono and holding a tray

High volatility – the nasty habit of share prices to veer about in a sickening rollercoaster fashion rather than trending along near some fundamental value – is a worryingly unpredicted emergent property of markets. Observing the apparently irrational bouncing about of stock valuations one might be tempted to wonder if this is happening less because of the markets adjusting prices due to changes in fundamentals and more, well, because sometimes stuff just happens.

The possibility that prices wander around in a random fashion for no particular reason – rather like the plot of a struggling sci-fi series trying to find a decent dénouement – is enough to give several generations of economists palpitations, not to mention unnerving the serried ranks of financial analysts who could find themselves put out of business by a decent Brownian motion generator such as a nice cup of tea. Under such circumstances they might actually feel better if it turned out that prices move about because people are irrational.

Volatility Rules

As far back as 1981 Robert Shiller pointed out that the fundamental valuation of the S&P500 computed historically – which roughly equates to the value of the index as a discounted stream of future dividends – followed an extremely stable trend. Basically, if you think of markets as efficient their fundamental value looks pretty constant over time. Yet, at one and the same time, the S&P itself wobbled around this stable valuation like a politician trying to avoid a paternity suit. Not unreasonably Shiller pointed out that it rather looked like there was unexplained volatility in the system. Up to thirteen times the expected volatility.

Such is the nature of these things that this sparked off a lot of debate which largely involved a bunch of economists, most of whom can individually start an argument in an otherwise empty room, metaphorically shouting at each other while brandishing large charts covered with hieroglyphics. Yet even while they were doing this markets continued to bound around in an enthusiastic but alarming fashion throughout the nineteen eighties before spectacularly collapsing on Black Friday in 1987 for no reason that anyone can discern with any certainty in hindsight (although lots of people have tried).

Intrinsic Volatility

Indeed, up to the present time, there is no variant of the efficient markets hypothesis – and there are a lot of variants – that can successfully and reasonably explain the excess variation of markets based on discounting the value of future returns. Volatility is the anomaly that simply refuses to go quietly into the good night: to the point where, eventually, a few bright economists wondered if it might not actually be an anomaly at all. What if, in fact, volatility is an intrinsic part of market behaviour?

In fact a proper explanation of volatility would need to somehow encapsulate the fact that it sometimes reverses polarity and goes off in completely the opposite direction from that exhibited previously. Sometimes it completely vanishes, for a while, before pouncing out and savaging investors when they’re not expecting it. All of this implies, of course, that markets suffer from significant periods of over and undervaluation.

Irrational Assumptions

The logic behind the efficient markets position is fairly clear cut. If stupid and irrational investors start to overbid for a stock then clever and rational investors, who recognise that the security is overvalued, will sell it. Although you may see a temporary over or under valuation accompanied by excess volatility eventually prices will come back into equilibrium as the basic laws of supply and demand come into effect.

This argument, of course, has a couple of fundamental flaws. Firstly, it assumes that there are sufficient clever and rational investors willing to balance the stupid and irrational ones – if there ends up being an imbalance between the smart sellers and bozo buyers then you won’t rapidly swing back to an equilibrium point.

Secondly it assumes that clever investors are in a position to take advantage of the errors of the dumb. If you assume that, for whatever reason, a particular stock ends up completely owned by idiots who then proceed to trade amongst themselves then they’ll bid the price up to higher and higher valuations in a toxic game of pass the ticking parcel. In such a runaway feedback situation the basics of valuation would go out of the window.

Excited slot machine player

A One-Way Bet

There are a number of recorded instances where this type of situation appears to have happened. This paper by Eli Ofek and Matthew Richardson records many instances of apparent valuation insanity during the dotcom era including the infamous situation where 3Com sold just 5% of Palm, a manufacturer of handheld computers that the mass of maladjusted mavens loose in the market at that point decided was a sure-fire hit. The frenzy of irrational bidding for these free-float Palm shares was such that the valuation of the 95% of the Palm stock still owned by 3Com exceeded the market valuation of 3Com itself. Yet it was impossible to take advantage of this situation because all of the available Palm stock was owned by excitable, irrational investors.

Ofek and Richardson also suggest another reason for excess volatility – heterogeneity of beliefs amongst investors. Essentially if everyone is captured by the zeitgeist of the moment then the market can only go one way, at least until the bitter reality of negative equity finally strikes home.

There may be another, almost rational, reason why volatility may not easily be put back in its box. Professional investors, incentivised to look for short term gains, will be inclined to ride momentum, buying into stock and market trends, rather than looking to bid against them. With such a short-term outlook this makes sense because momentum tends to hold over shortish periods of up to a year while mean reversion effects apply over longer timescales, often up to three years. If major elements of the investing community aren’t willing to bet against trends on the basis of fundamental valuations then it’s no surprise that volatility can overshoot in either direction.

When Is Smart Too Smart?

In fact it’s probably worse than this, because instead of smart money diminishing the volatility of markets and driving them back towards a fundamental valuation it appears that it often has the opposite effect. De Long, Shliefer, Summers and Waldmann suggest that the really smart money aims to outsmart the irrational, behaviourally compromised investors by buying in ahead of them, aiming to make money by flipping their holdings. So much for efficient markets and the smoothing out of volatility by intelligent investors. Who’s smart now, then?

Pere David's Deer In Qintong Wetland Nature Reserve

Behavioural economists, of course, don’t find any of this very surprising. People get excited, pay too much for investments and drive them to highs unsustainable by future earnings. Volatility is the outward sign of this and, as such, is a powerful signal for contrarian investors. When the herd is running, run – the other way.

Related Articles: Pricing Anomalies: Now You See Me, Now You Don’tTo Predict the Next Bust, Ask an AustrianDarwin’s Stockmarkets 

 

Subscribe
Notify of
0 Comments
Inline Feedbacks
View all comments

Stay Connected

157,450FansLike
396,312FollowersFollow
2,280SubscribersSubscribe

Latest Articles

0
Would love your thoughts, please comment.x
()
x