Why stocks are volatile

The New York Times reports that stocks have been highly volatile in the past three years:

Market Swings Are Becoming New Standard

The stock market just can’t seem to make up its mind.

Day after day, stocks swing sharply by hundreds of points. Last week they tumbled 3 percent in the first 90 minutes of trading on Tuesday morning, then on Wednesday closed nearly 3 percent higher and dropped almost 3 percent on Friday. All of this on the heels of unusual back-to-back 4 percent leaps and dives in one week in August.

There is no mystery to this volatility.  When there is great uncertainty about the future course of AD, stocks are highly volatile.  When NGDP growth is relatively predictable, then stocks merely react to real fundamentals.  As a practical matter, AD uncertainty is most pronounced when NGDP is far below the level the stock market (or the public) would prefer.  In that case, stocks gyrate wildly on hints of policy shocks that might affect the future course of NGDP.

This is not just an ad hoc theory.  Think about the fact that the standard deviation of daily changes in the Dow was about 2% between 1929-38, and about 0.8% in other decades.  The 1930s were the decade of excessively low NGDP, and also great uncertainty about policy changes to address the problem.  As an example, 1931 and 1932 were especially volatile.  I believe the largest two day stock rally in US history occurred in February 1932 after Hoover announced a deal to loosen regulations on how much gold was needed to back currency.  This allowed the Fed to do open market purchases.  Interestingly, the program was probably not effective, but the key point is that the markets understood that low GDP was the main problem.  It was worth a shot.  I could cite innumerable other examples from the 1930s.

Here’s an amusing paragraph from the same article:

Some financial historians question whether the markets are in a “new normal” of permanently heightened volatility.

“The last few years have been the most volatile for all of recorded history,” said Andrew Lo, professor of finance at the M.I.T. Sloan School of Management. For evidence, he says that 10 of the biggest 20 daily upswings and 11 of the largest 20 daily drops since the beginning of 1980 to the end of last month have occurred in just the last three years.

That’s funny; I thought the recorded history of economic transactions began in ancient Sumer.  I guess the “financial historians” at MIT have a more restrictive definition.

BTW, if the structural theories of the recession were correct, stocks would probably not be particularly volatile.  Structural problems are already priced in.



21 Responses to “Why stocks are volatile”

  1. Gravatar of Steve Steve
    12. September 2011 at 08:58

    Andrew Lo is a quant. If you are a quant, history begins with the computer age.

  2. Gravatar of Scott Sumner Scott Sumner
    12. September 2011 at 09:02

    Steve, Yes, but there are databases that have daily changes in the DJIA going back to the early 20th century (at least.) Anyway, I was just kidding around, I do get your point.

  3. Gravatar of Morgan Warstler Morgan Warstler
    12. September 2011 at 09:05

    Everything will go back to normal when Rick Perry is President.

    Once we undo Obamacare and get started slashing government spending / cutting taxes on Tea Party folk.

    EVERYONE who maters will then favor a easier money policy.

    After all, the correct painful measures were taken.


    Your best strategy: YOUR GOAL should be make your NGDP policy THE RATIONAL the right will use AN12 – after all your is a THREEFER.

    1 – easier money in near term.
    2 – less chance of a repeat of 2002-2008.
    3 – the Fed is neutered, they are run by a PC.

    It’s 1 year a way. DO NOT waste your time with the chattering classes, lay down your bets on a Parry admin, and start to earn the respect of his supporters – they will NEED your plan, but they must TRUST you to go the full Sumner monte.

  4. Gravatar of Benjamin Cole Benjamin Cole
    12. September 2011 at 10:08

    Interesting post.


    Rick Perry strikes me as a bilious knave, a vile excretum from the southern portal of Texas, freshly landed on the national stage.

    I doubt he makes it the the Presidency, or perhaps even the Republican nomination. Right now, he can’t even make it to press conferences he schedules himself.

    Perry’s view that Galileo was wrong until the Roman Catholic Church said he was right speaks of a dim-bulb intellect. As in, the power is turned off.

    The roar of approval at the recent GOP debate regarding Texas executions suggests that when Perry says he wants to try Bernanke for treason, he was not joking, and he had a precise penalty in mind.

    Perry is in his element as Texas Governor, an institutionally weak position where he can do little harm. He is a Third-World Commissionista, and that is what he should stay. Do the nation a favor and confine him to the state borders.

  5. Gravatar of Morgan Warstler Morgan Warstler
    12. September 2011 at 10:16

    Sorry Benji,

    He’s going to be your next leader.

    But there is upside, your state (Cali right) will get to keep its $ and its liabilities to itself, and you’ll be able to remake the entire west coast into a glorious beacon like Thailand.

    Not that Full Moon isn’t nice.

  6. Gravatar of StatsGuy StatsGuy
    12. September 2011 at 10:16

    I have a theory for you Scott – several, actually.

    In a 0% nominal interest rate world with uncertain policy, there’s no alpha. Everything is “priced in”. So, the NPV of any shock to future values is higher. In other words, zero alpha, all beta. Take that, add it to anemic real liquidity (70% of stock trades are now executed by computers trading to computers, also known as HFT), add in some algorithms that are specifically built to front-run known behavioral biases, then stir the pot with quote stuffing malicious algorithms specifically designed to create volatility to benefit on options plays and by increasing perceived risk on high beta stocks.


    Add to that the feedback that stocks have to the real economy through signalling confidence, the utter incompetence of politicians, and a _massively_ leveraged financial sector with large segments that are hovering near insolvency (where there is a very big non-linear return called a “liquidity event”).

    Oh, and that’s just the stuff we KNOW about. Then there’s all the conspiracy theories that might just have a kernel of truth.

    It’s not a perfect storm. It’s worse.

  7. Gravatar of Benjamin Cole Benjamin Cole
    12. September 2011 at 10:34


    Perry is like Bush jr. minus the IQ. In the end, I think Romney will prevail—and Romney may even take the whole enchilada.

    But remember this: A lifetime in politics is six weeks. No one thought McCain was going to the GOP nominee.

    Perry is this moment’s flash-in-the-pan. Bachmann was last week’s flash. There may be a new flash tomorrow.

    Karl Rove is openly advocating that somebody new–anybody–enter the race. Boy, when it comes out that Perry is a closet homosexual–you think he will win the GOP nomination, after that?

    This is the GOP national we are talking about, not the Bay Area, or even Austin.

  8. Gravatar of John Thacker John Thacker
    12. September 2011 at 13:24

    “Perry’s view that Galileo was wrong until the Roman Catholic Church said he was right speaks of a dim-bulb intellect.”

    I really don’t like Perry, but that’s not what he said about Galileo at all. If you really believe that that’s an accurate paraphrase, then you must have a really dim-bulb intellect. After all, part of intellect is understanding what other people are saying.

    His argument was that Galileo was right *even if and when* the consensus, embodied in both the Vatican and the “scientists” who followed Aristotle’s flaws ideas of physics disagreed. “I mean… just because you have a group of scientists that have stood up and said here is the fact, Galileo got outvoted for a spell.”

    I think it’s very reasonable to attempt to argue that the “consensus” was not really against Galileo, or to argue that even if the scientific consensus were against Galileo that politicians should follow the scientific consensus until it changes rather than embracing a minority view, and so forth.

    Lots of decent criticisms of his views. However, Benjamin Cole’s criticism is one that only a dim bulb intellect could make.

  9. Gravatar of JimP JimP
    12. September 2011 at 13:46

    Barney Frank on the FOMC


  10. Gravatar of Morgan Warstler Morgan Warstler
    12. September 2011 at 15:00

    John Thacker,


    It’s Benji, he likes to let his pen fly a bit when Rick Perry and Texas – ntr mush else has been going well for him politically.

    The real tally will come when Rick Perry is POTUS, because when everything turns on a dime, and suddenly we have to have monetary, there will be some C I toldjaso, and some here will suddenly STOP wanting it.

    The point is if we’re really going to have something new rootin tootin like level targeting NGDP at 3%…

    It’s going to take the will of a man like Rick Perry – who will sell it, or something near it, as a way to HOGTIE the Fed.

    And the Tea Party will rejoice.

    The question is whether Scott gets the credit.

    Because if he hasn’t been serving up red meat like the Golden Corral and made it clear that his magic should only be used at certain special times, he might not be the one everybody pats on the back for helping Rick Perry to save America.

  11. Gravatar of Scott Sumner Scott Sumner
    12. September 2011 at 16:36

    Morgan, The worst thing about Perry running is now I have non-stop posts from you on the subject.

    Statsguy, I’m not saying you are wrong, but I don’t follow the alpha argument. Why don’t firm-specific shocks still matter at the zero rate? BTW, obviously not all profits are discounted back at zero, or stock prices would be near infinite.

    JimP, That’s actually a reasonable argument by Frank. And given inflation has averaged 1% over the past three years, it doesn’t look like those dissents were correct.

  12. Gravatar of StatsGuy StatsGuy
    12. September 2011 at 16:52


    “BTW, obviously not all profits are discounted back at zero, or stock prices would be near infinite.”

    Not quite true. There’s time discounting (the interest rate), and risk discounting. Interest rate can be zero (or below zero – if future consumption is more valuable than present consumption). Think of it how credit default swaps separate out bond rate (time rate, inflation risk, and default risk). Risk discount can _never_ be zero, by definition. But that’s consistent with the observation – as nominal rate approaches zero, all of the discount becomes risk, not time.

    Let’s say microsoft generates a profit stream, but at any moment the profit stream could dry up subject to random chance. Even if time discount rate were zero, total discount rate is non-zero.

  13. Gravatar of Morgan Warstler Morgan Warstler
    12. September 2011 at 16:55

    Turn on CNN Debate, we’re getting ready to talk about the Fed.

    These are the people you HAVE to convince Scotty my boy.

    Roll around in them, get their stink on your good, learn their handshakes and mating calls you can sell it!

  14. Gravatar of Morgan Warstler Morgan Warstler
    12. September 2011 at 16:57

    Here it comes…

  15. Gravatar of Morgan Warstler Morgan Warstler
    12. September 2011 at 17:02

    End dual mandate.

    King Dollar.

    Fed transparency.

    No Congressional oversight.

  16. Gravatar of Bonnie Bonnie
    12. September 2011 at 19:18

    “BTW, if the structural theories of the recession were correct, stocks would probably not be particularly volatile. Structural problems are already priced in.”

    This might be true if the structural problems were static. If we have a regulatory apparatus on steroids that keeps changing the equation not in subtle, but dramatic ways, it might play into some of the volatility. It’s a bit hard to tell from the data presented here in this post because in addition to suboptimal monetary policy during the 1930s, there were also dramatic regulatory changes starting in 1933.

    ObamaCare might already be priced into the market, but I couldn’t say that with any certainty because it’s doubtful there’s a clear understanding of the full impact; and the same goes for Dodd-Frank. Both of these laws reach far and wide, with rather nebulous legislative guidelines and the rule-making process for them is still in the embryonic stages. At this point the only thing I think is certain is uncertainty.

  17. Gravatar of Bonnie Bonnie
    12. September 2011 at 20:24


    I have no inclination toward people who complain about dollar depreciation in one breath and then complain about Fed intervention in currency exchange rates to defend the dollar in the next. That is exactly what Michelle Bachmann did, with the rest of the candidates nodding their heads in agreement. Is that what you really want, monetary dunces in charge who would appoint kindred spirits of the Bank of Japan to the FOMC?

    There is no practical way to have a strong dollar with a weak economy, current public debt at $15T and rising, social security alone being underfunded to the tune $28T, along with a regulatory apparatus that’s completely out of control and incoherent with competitive pressures of a global economy. If you want a strong dollar, it has to be earned the hard way by cleaning up the mess – all of it. If we try to get a strong dollar with all of those other problems still in the background, it means more of the same kinds of market manipulation that are supposedly despised, and more economic problems for the majority of us who really have just had enough of this recession and the heartache that comes along with it.

  18. Gravatar of Lorenzo from Oz Lorenzo from Oz
    13. September 2011 at 05:08

    This graph (from a Mark Perry post) would appear to be another way of making the same point about the effects of NGDP uncertainty, since investment spending is much more forward looking than consumption spending. Though, as Karl Smith makes clear in this post, different forms of investment are varying greatly in recovery (or not).

  19. Gravatar of flow5 flow5
    13. September 2011 at 08:09

    “When there is great uncertainty about the future course of AD, stocks are highly volatile”

    That’s an understatement. Take the Commerce Dept’s July 29 2011 revisions back to 2003 that showed the recession (ngDp), to be worse than originally thought. This triggered a huge sell off.

    Take Feb 27, 2007 “On Feb. 28, Bernanke told the House Budget Committee he could see no single factor that caused the market’s pullback a day earlier”. In fact, it was home grown (i.e., a very sharp collapse in the rate-of-change in ngDp/mvt). It was the seventh biggest one-day point drop ever for the Dow.

    Take the May 6, 2010 “flash crash” plunge of 1000 pts. ROC’s in Mvt predicatably triggered this plunge (& so on & so on).

  20. Gravatar of Benjamin Cole Benjamin Cole
    13. September 2011 at 08:15

    Perry “could barely compose a sentence without looking as though he might pass out from exhaustion,” wrote John Podhoretz.

    Read more: http://swampland.time.com/2011/09/13/about-last-nights-debate/#ixzz1XqkDI4iv

  21. Gravatar of Scott Sumner Scott Sumner
    13. September 2011 at 17:41

    Statsguy, So the risk free rate is near zero, but the rate used for discounting is higher?

    Morgan. I don’t watch the debates.

    Bonnie, My sense is that the huge day to day swings are not due to changing perceptions of things like Obama-care.

    Lorenzo, Yes, I is much more volatile than C, or GDP.

    flow5, Too many acronyms. Use more words. (And I am interested in stock responses, so I’m not just being critical.)

    Ben, Seems like Morgan’s horse might not be ready for the big race.

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