Understanding Market Volatility

Investors and traders alike need to understand market volatility.  Many market observers use volatility as a euphemism for price declines.  This is completely wrong.

The astute options analyst Adam Warner (one of our featured sources), does a great job with this concept.  Writing about the Market Vectors Gold Miners (GDX), he makes this important point:

Volatility is about fear of the unknown, and so long as gold and currencies get out of range a bit, there's apparently a bit of fear around of either missing another leg up or missing an about face down. (emphasis added)

A Natural Human Trait

Accepted lore is that markets hate uncertainty.  It is a normal human trait, one that is manifested in collective behavior as well.  Here is a simple example.

Airline passengers are quite sensitive to the unusual.  I was thinking about this on my trip this week to the West Coast.  (I always expect to post an article or two on these business trips, but usually fail.  Sorry!)  My seatmates on both flights had a lot to say about the pilots who somehow missed their destination, flying 150 miles past the airport and losing contact with air traffic control for more than an hour.  Everyone I talked to was confident that the pilots dozed off, and dismissed other explanations.

I fly on United and enjoy the flight deck feed on Channel 9, the conversation with ATC and the towers.  The Wall Street Journal cited the calming effect of this feature:

Many passengers take comfort in the back and forth between pilots and air-traffic control. Mr. Ohnstad, a technology project manager in the banking industry, says he sometimes worries about noises and jolts while in flight. "But I hear the pilot's calm voice telling ATC that 'We're experiencing continuous light chop,' and I can relax more," he said. "It's fear of the unknown that causes apprehension. Pilots can't update you every 30 seconds."

Personally, I have often enjoyed specific benefits from the flight deck commentary--often warning that choppy skies are ahead.  The funniest case was when we were parked at O'Hare waiting for a gate and the pilot asked for a small move to a new parking spot.  His passengers were getting restless!  I was one of the few to know the secret.

Anyone who flies often will enjoy the excellent blog from Captain Dave, who provides inside information from the perspective of the pilot, including an insightful treatment of the recent incident.

Applying the Lesson to the Market

When following the market, an explanation of each day's trading can be a calming influence, just like communication from the pilot.

The problem?  The explanations are all different and generally lack any evidence.  Here are today's candidates.

Business Week explained as follows:

U.S. stocks closed sharply and broadly lower Friday, led by financial issues, as disappointing reports on personal spending and consumer confidence stoked investors' concerns about the economy. Treasuries jumped as stocks skidded.

MarketBeat had a similar take:

For months, investors have worried that the recovery of both the economy and the stock market had more to do with heavy government stimulus than with fundamental economic improvement. Now those fears are raising their heads again.

The concerns sent stocks down sharply back on Wednesday, but seemed to dissipate Thursday, as a stronger-than-expected government estimate of third-quarter economic growth helped stocks erase the week’s losses in a single day. Today, weak reports on consumer spending and consumer sentiment have put the bears in the driver’s seat again.

Briefing.com has a very different viewpoint:

There wasn't any immediate cause for this session's decline, though some market watchers point out that stocks have had an increasingly difficult time of climbing higher since making their strong runs in recent months. Others have pointed out that there may be some month-end portfolio rebalancing and window dressing accounting for the recent whipsaw trade.

Nonetheless, the concerted selling effort brought about a spike in volatility. That sent the Volatility Index, often dubbed the Fear Gauge, up 24%, which marks its sharpest single-session spike by percent this year. Moreover, the VIX now stands at its highest level since July. Complementing the spike in the VIX is an elevated put-to-call ratio of 1.2, which is indicative of positioning for downside protection.

Art Cashin, a great reporter of floor sentiment, emphasizes the relationship between stocks and the dollar.  He notes that there is a high correlation -- weak dollar, stronger stocks.  He believes there is great risk in a dollar spike.  The CNBC interviewer pushes him hard on the nature of this relationship, suggesting that both the dollar and stocks are reacting to a change in appetite for risk.  Watch the video, beginning at 3:21.

Our Take

The question to Cashin was a good one.  It is what is called a "spurious" relationship.  Two variables are highly correlated.  Observers, in this case the NYSE floor traders, infer causation.

Here is an example I used in class.  You have a person in the middle of a traffic intersection with a stoplight.  When the light turns green in a given direction, he waves the traffic to go through.  The actions of the guy doing the waving are perfectly correlated with the traffic movement, but there is no causation.

Now let us suppose that the traffic light is out, and the person in the middle is wearing a police uniform.  The inference of causation is quite different.

Proving causation requires more than showing a correlation.  It requires solid evidence of timing, one variable leading another, and also a strong hypothesis about the logic of causation.  It is also useful to have statistical controls.  Art Cashin is on target when it comes to the floor trader attitudes, but they might all be fooled by a spurious relationship.

Meanwhile, there is plenty of evidence that the market is currently trading on perceptions of economic strength.  It is quite possible that we could see a stronger economy, a stronger dollar, and stronger stocks.  Or the opposite.

This explanation may not be comforting to investors, but at least it suggests what to watch.  That remains our focus.

Comments

[oldprof]

Adam -- You are quite correct in sensing our pain. My wife grew up in Green Bay, and I lived in Wisconsin long enough to form loyalties.

It was a tough day for Packer fans!

Jeff

[oldprof]

Al -- Thanks for another good example.

If more people understood causation, we would all recognize this every day.

One of my favorites is when the analysts say that if Team A's running back goes for 100 yards, they always win.

They seem to miss the concept that a team leading by a nice margin runs the ball.

Thanks again.

Jeff

[Adam]

nice stuff and belated thanks for including me in there. The causation stuff on TV drives me nuts, it's such awful advice some casual listeners must internalize without giving a second thought.

And sorry about Packers yesterday, I imagine they'd trade losing every other game this year to win that one.

[Al Brockman]

Very perceptive - few people seem to understand the difference between correlation and causation. Great example (if i remember right) in the book "How to Lie With Statistics" (Should be a must read for anyone trying to understand the economy/market). There is a direct correlation between shoe size and SAT score for high school students. High school seniors are usually taking the test for the second time and usually do better. They are older and have bigger feet. No causation!!!

[oldprof]

Morph - If you have been reading here for a while, you know that I am a big fan of Art Cashin. It is important to know what people on the floor are thinking, and Art is the best for providing that insight.

Your account of the interview is accurate, as anyone can see by going to the link as I suggested.

You might be surprised that a leading foreign exchange expert frequently writes that the causation is exactly the opposite -- stocks leading the dollar.

To suggest that something is spurious is definitely NOT saying that it is a coincidence. It means that an apparent relationship between B and C can occur if both are caused by A. In my traffic light example, the regular guy looks at the signal as do the drivers. To someone looking just at the person giving "directions" and the motorists, it may seem that the two are related. It is definitely not a coincidence, but it is a spurious relationship.

As I noted in the article, we lack the evidence to infer the causal model in this case, and I have no opinion. I do believe that many, and perhaps most, relationships you see in economic and stock market discussions are spurious. So many things are all indicators of the same phenomenon.

I hope this is a better explanation, and I appreciate your comment.

Jeff

[Morph366]

I watched the Cashin slot and think that he acquitted himself well on the accusation of inferring a causation between the dollar and stocks.
There undoubtedly is a strong inverse correlation and the manner in which the traders of forex and equities echo each other within micro seconds makes it impossible to isolate the actual causal sequence - but you are surely not suggesting that the high correlation is a coincidence? That is certainly the under-current to the suggestion that it is spurious