I attended a symposium in Austin, Texas recently where the esteemed finance professor, Gene Fama, addressed our group. If you aren’t familiar with Dr. Fama, he is one of the pioneers of Efficient Market research, is often referred to as “the father of modern finance,” and has been a candidate for the Nobel Prize in Economics. So, to borrow the old E.F. Hutton line, “when Dr. Fama speaks, people listen.”
After his presentation, Dr. Fama took some questions from the crowd, and his response to one of them caught my attention. When asked for his perspective about the extreme volatility that has been plaguing the financial markets since August – and, really, since 2008 – he had an interesting response.
“The volatility we have seen is not unusual from a long-term historical perspective,” Dr. Fama said. “But it is unusual compared to the volatility we became used to over the past few decades.”
This may be hard for you to believe, but it’s easy to see looking back at the historical record. While volatility in recent years has spiked, it is consistent with other times of turbulence, notably the 1930s and ‘40s (and in truth, it has been a good deal less volatile than the Depression era). This may not exactly be comforting, but it is at least informing.
“But wait!” you say. “Why do I keep reading about the ‘unprecedented volatility’ we are seeing in the market today?”
The answer is that the media isn’t interested in perspective, it is interested in drama. Financial reporters love to focus on point declines in the market, because it draws people’s attention. And when reporters get to go on air and breathlessly tell us that the Dow experienced, say, its fourth-largest point decline ever, that makes for some captive viewers.
Point declines, however, are very different from percentage declines, and percentage declines are really the only logical way to judge volatility. After all, a one-day drop of 500 points at Dow 12,000 is not nearly of the same significance as it was at Dow 2,200, which happened in October 1987. At Dow 12,000, that decline was about 4%; at Dow 2,200 it was about 23%.
In that regard, consider the following list of the 20 largest one-day percentage declines in the Dow Jones’ modern history:
Notice anything interesting about this chart? That’s right – not one of the declines from recent weeks even made the top 20 largest percentage declines. And even at the height of the panic in 2008, only one day cracked the top 10. So I take exception with the argument that these swings in the market have been unprecedented.
This isn’t to say, however, that the recent swings haven’t been unusual. Referring back to the table, it is interesting to note that fully 50 years passed between the 1937 downturn (at #11) and “Black Monday” 1987, the mother of all one-day percentage declines that is #1 by a large margin.
Looking back at a timeline of one-day percentage swings of 3% or more in the Dow from 1928 – 2008, we can see this trend in which volatility took a long holiday during middle part of the century: So while we can’t say the market volatility we have seen in the past few years has been unprecedented, we really have to go back to the Depression era to find a time that rivaled our current market environment. This is consistent with a central reality: Financial crises lead to extreme volatility in the financial markets, and until the crisis is resolved, the volatility will likely remain. And we are in the midst of the worst financial crisis we have seen since the 1930s.
While politicians trade in rhetoric, markets deal with realities. And the reality the market sees right now is a heavily indebted developed world that can’t meet its obligations. And so, in its own heavy handed way, the market is forcing the issue by essentially voting on the policy moves that European and American governments are making to improve their balance sheets. The market is applying pressure to politicians by giving a Bronx cheer to any efforts it deems ineffective in getting our debt crisis under control, and the same thing is happening overseas in Europe. And this is serving to force our politicians to deal with things they’d just as soon kick down the road to the next crisis.
In the short- to intermediate-term, therefore, stock volatility may well be like the relative who drops by and then just keeps hanging around, wearing out his welcome. In the long run, however, issues and crises have a way of resolving themselves. As the old economic saying goes, “If something can’t continue, it won’t.”
This is where long-term investors need to be extremely careful about the dangers of, as financial writer Nick Murray refers to it, “Volatility Fatigue.” After years of enduring wild swings in the market, it can be easy for investors to throw in the towel and flee the market “until things calm down.” But the stock market is a leading economic indicator, and things turn decisively upward in the market long before crises resolve themselves.
We saw this coming out of the bear market lows in March 2009, and no doubt we’ll see it again as events in the developed world resolve themselves in the years ahead. Alas, just as we saw two years ago, most of the investing public will be on the sidelines when it happens.
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