The many faces of market volatility

As an options trader, market volatility is a near-constant concern for me; understanding and responding to it defines much of my job on a daily basis. The dramatic spike in volatility in the last two years has meant that all investors, not just options traders like me, have become highly sensitive to developing trends in volatility.

It is my firm belief that anyone who chooses to be involved in this market (or any market) must understand the different faces of market volatility, so that they can better recognize the risks and rewards of their investment strategies.

I have pored through historical data on the S&P 500 Index (SPX), and summarized some of my findings below. My aim in this post is to describe, rather than to analyze--every investor has different risk tolerances, so the responses to this data are bound to be mixed. But I found many of these trends to be interesting, which is why I feel compelled to share the data. Enjoy.
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Considering all of the data going back to 1957 (when the SPX in its current form was first published), I came away with three primary findings of relevance to today's investor.

1) Daily and weekly volatility have increased

This is hardly news to any investor. Some of the one-day (and one-week) moves recently have been downright scary, and these moves are a primary reason behind the massive outflows from equity funds in recent months. 

Both daily and weekly moves are increasing in magnitude (though the trend is far from smooth). The long-term average daily move in the SPX (since 1957) is 0.67%--the years 2008 to 2010 have seen average daily moves of 1.74%, 1.24%, and 0.91%, respectively. 2008 also saw an average weekly move of 3.18%, versus a long-term average of 1.56%. These are big, fast moves. 

2) Larger bull/bear market trends have remained essentially normal

Despite the significant increase in the velocity of the market, as evidenced by the first point, larger trend moves have been basically normal. If we consider anything greater than a 10% move to be a "trend", we see the following trending markets (top 5 of each type):

The 2007-2008 market sell-off, while the largest in magnitude since the SPX was first published, was not dramatically different in size or duration from previous bear markets. It was, of course, followed by a second bear market from January 2009 to March 2009 (27.4%), but this came after a significant bounce in the intervening months. You will also notice that the responding bounce off of March 2009 lows did not even register in the top 5 bull markets.

Bear markets, in general, tend to be fast. They are not, however, necessarily scary. The market sold off a total of 39.2% from May 2001 to July 2002 (with a couple of 20% rallies breaking it up along the way), but never once had a daily move greater than 5%. It was a perfectly normal, steady sell-off. Trend volatility and short-term volatility, as this example shows, do not necessarily track each other. BUT...


3) Fall 2008 was completely insane

There's simply no other way to say it. Since 1957, there have been a total of 38 trading days where the SPX has moved more than 5% (17 positive, 21 negative); 18 of those occurred between September and December of 2008 (7 positive, 11 negative). Furthermore, 3 of the 5 largest up days and 3 of the 5 largest down days since 1957 occurred in that same period. In short, 50 years of market movement were crammed into 3 months.

It is impossible to know yet whether the fall of 2008 is a one-time aberration or indicative of a new age in the financial markets. The months since have been more volatile on a daily and weekly basis than previous years, but not at a level unseen previously.

The fall of 2008 is still fresh in our memories, and time will tell if it is a warning sign for the next generation of investors. Many investors look at the "flash crash" of this May in tandem with that ugly fall, and draw conclusions that the market is irreparably broken. But "flash crashes" are not new, either.

Either way, the lesson of the last two years (I know, I said I wouldn't analyze, but I can't help myself) seems to be that while market velocity has increased, large-trend volatility has not. Now more than ever, the smart investor must look past the short-term and focus instead on longer-term trends.

[Yahoo! Finance]