There’s no doubt that equity (and other) markets have been more volatile this year than in 2015. This partly reflects the fact that declining markets tend to see wider and more erratic price swings than bullish counterparts; the fear of losing money is a more powerful driver than the fear of missing out. Because emotional buying-and-selling is by definition less rational and more easily influenced by market trends, it can exacerbate turbulence and price swings that feed on themselves.
Moreover, when markets rise or fall sharply, that is often the catalyst for stop-loss trades, margin-calls and other transactions where the price at which trades are executed is less important than the fact that positions must be closed and risk exposure reduced. Although such “forced” transactions can occur in any environment, the long bias in equity, bond and other markets invariably means the pressure tends to be most acute when prices are moving lower.
The downside of leverage
The effect can be especially pronounced when leverage is involved. As the following chart shows, margin debt, which is used to finance equity (and other securities) holdings, has expanded dramatically in recent years. If prices start moving in the wrong direction–that is, down–losses are magnified. A 10% share-price drop translates into a 20% capital loss when a position is supported by a loan equal to 50% of its value. If other, more highly-geared financing is involved–as with, say, a short option position–the red ink bleeds at an even faster rate.
Even in those cases where a market is not witnessing the kinds of price swings that might be expected to trigger liquidations, chaotic conditions elsewhere can have an impact. That is because many institutional investors operate under frameworks that can spur forced risk-reduction across sectors and asset classes. The first is “portfolio margining,” where brokers or other intermediaries provide financing backed by an array of holdings. If problems in one area impair a portfolio’s aggregate value, investors may feel compelled to sell whatever they can to meet lender calls for more cash collateral.
A shift in the volatility regime can also spur actions that reverberate broadly. Most financial institutions, including investment banks, commercial banks and hedge funds, rely on a statistical measure called “value at risk,” or “VaR,” to gauge how much they may lose if things turn sour. History suggests this risk-management approach spurs widespread efforts to close out positions when turbulence increases, augmenting the trend. The widespread use of similar risk-management models can make matters worse, as many firms end up trying to unwind equivalent exposures at the same time.
Diminished liquidity and lower turnover
Another reason for heightened volatility, discussed here and here, is that markets are less liquid than they used to be. That is reflected in wider bid-ask spreads–the differences between what buyers will pay and the prices at which sellers will trade–have widened, while market depth–which reflects the quantities that participants are willing to transact at any given point–has fallen. In either case, when an order hits the market, it tends to push prices further away from where they were at the point of entry than in the past.
Furthermore, while trading volumes have recently picked up as prices have fallen, turnover has, on balance, been in a secular decline. That has been driven by various factors, include the broad shift towards less active strategies, which was discussed in “Are Passive Investments as Risky as Hedge Funds?” as well as evolving investment and investor preferences. Ultra-low interest rates, for example, have spurred an interest in fixed-income and certain nontraditional investments, many of which involve private markets (a topic touched on here and here).
Greater uncertainty about the economic outlook, especially in light of the Federal Reserve’s move to increase interest rates, which some observers feel was a mistake and others believe is the first of many, is also contributing to larger intraday and intersession swings. Up until last summer, the Fed had gone out of its way to reassure investors that they would be kept informed about what the central bank was expecting and what it might do next, creating a consensus that was notably tighter than it is now. Needless to say, the fact that China, the world’s second largest economy, also appears to be wobbling only makes matters worse.
The same reassurances that inspired confidence about the outlook also spurred widespread complacency. Together with the aggressive hunt for yield that has transpired over the past seven years, that has led investors to take on more risk, funded in many cases by overly aggressive financing, than they might otherwise have been comfortable with. With the future more uncertain, those who were caught wrong-footed have been jarred into action, adding to overall market turbulence.
If history is any guide, the recent surge in volatility will eventually abate, and things will return to some semblance of normalcy. That said, it seems apparent that the relatively benign conditions of the past several years were, perhaps, as abnormal as the policies and actions that helped to create them. Now that the game has changed, it’s a good bet that some higher level of day-to-day market volatility is here to stay.