Market Volatility Explained

Said most simply: volatility is change.

A concrete manifestation of volatility is when prices change. This happens every day.

When most people describe volatility in markets, they are referring to downward price movements. The majority of people are long stocks after all, so they are not likely to complain if their prices move higher.

The most used metric to measure market volatility is the VIX index.

The chart above shows that the VIX does not move like the stock market, which generally moves higher over time. The VIX is measuring how sharp the changes in prices are. Hence the highest levels being reached during the Great Recession and COVID-19 lockdowns.

But it is worth mentioning that upward price movements are still examples of market volatility, even if most people like it, short sellers or market bears may not.

The most current examples of this are the AMC and GameStop surge in prices. Implied volatilities of these stocks are calculated by how expensive options to buy those respective stocks are. The blue line below shows the volatility of GameStop peaking in January around the same time its stock price did.

Weimar Germany was famous for its hyperinflation, which planted the seeds for the rise of the Nazi Party and experienced significant volatility in stocks and other assets as their prices rose. Much of the real value of the underlying assets was destroyed and the actual price increase was driven by the currencies’ loss of value. Less dramatically, the same pattern occurred in the late 1990s during the tech boom. Of course, that ended with the Nasdaq’s collapse. Thankfully today, these run-ups in volatility along with rising stock prices have been limited to a few “meme stocks”.

While many investors are focused on the VIX and price movements in stocks, volatility still has an important impact on bonds, currencies, and commodities as well. Sometimes upwards volatility in one means the inverse of the other. This is a good example of upward price volatility affecting the everyday consumer. If prices of certain goods go up, consumers are unhappy. The 1970s are a prime example of inflation causing a lot of volatility in bond, equity, and commodity markets.

Changing prices should reflect change in the real world. Whether that be a new business line from Amazon pushing pharmaceutical stocks lower, or a regime change in a foreign country, persistent volatility in prices reflect uncertainties in the real world.

Depending on the investment strategy and current positioning, market volatility has the potential to be a friend or foe.

Some strategies use low volatility as an opportunity to add debt, “lever up” in high finance speak, and magnify the returns of their strategies. Because debt magnifies both gains and losses, these strategies employ strict risk management policies to ensure that losses are cut early and often.

Volatility is considered a foe to these strategies. When prices start to move in unfavorable ways, investors will then likely lower their exposures to these investments. While volatility is not this investor’s friend, they watch it diligently to put leverage back on when volatility in the market is at more normal levels.

Other investors who sit heavy in cash will lick their lips at the sight of volatility. Often these investors are well-versed in numerous businesses that they feel trade at higher prices than they are willing to pay. These investors can then deploy their cash into investments when they see an opportunity from the market volatility!

Another class of investors trades options and other complicated derivative products that go up in value when the prices of stocks go down (or up). While these strategies are complex and can be tough to understand, they are less conventional.

To some managers, volatility in terms of price movement is paramount. They do not care about root causes but use volatility as a signal to take down risk and sell their positions.

For others, identifying key risks helps investors hedge out specific risks, avoiding volatility in their portfolio altogether while firmly holding onto their positions.

And while individual investors of various strategies can all succeed, someone always gets carried out of their positions on a stretcher.

Think of it like this. To get into a nightclub, there is a nice orderly line to get in. Each group that gets in represents one day of trading. However, when risk appears, such as a fire breaking out in the club, everyone runs and tries to exit at once, causing pandemonium! But not everyone can fit through the door at once…

In markets, if a lot of people want to settle their trades during a crisis, the solution is for prices to go lower (or in our nightclub example, for the doors to widen) so all the orders that might normally occur over an extended period of time can get filled.

Rigidity is not stability.

Skyscrapers are designed to sway. Cars have crumple zones to absorb energy during a crash.

Things that are built with zero cushion have the potential to collapse, not in spite of their strength, but because of it.

Lack of volatility can plant the seeds for future volatility. This was a famous insight of the economist Hyman Minsky, whose eponymous Minsky Moment was exemplified by the 2008 Great Recession.

The trajectory of the Minsky Moment is as follows:

1) Projects are only funded with debt when the underlying projects can completely afford to pay back the lenders.

2) Next, projects that can afford to pay back interest payments but require refinancing get funded.

3) Projects then get funded that require rising asset values in order to pay back the lender or refinance.

4) Finally, once the absurdity of the whole process is discovered, the system collapses on itself.

These types of collapses should only occur after leverage significantly increases in the face of low volatility during the more sustainable and prosperous stages of the economic cycle.

“Hard times create strong men, strong men create good times, good times create weak men, and weak men create hard times.” - G. Michael Hopf

Or in economic terms, bull markets encourage risk-taking which creates weak balance sheets.

When corporations or entrepreneurs take on loads of debt, they have little room for error. They have little wiggle room, like a skyscraper that is built without the ability to sway.

Inflationary environments can be very volatile. Former Chairman of the Federal Reserve, Paul Volcker, stopped inflation but hurt the economy so that it could eventually restart without inflation.

Our current policymakers seem determined to avoid any economic volatility that may occur in the markets. In our inflation piece, we wrote about how the Fed is prioritizing employment over inflation.

As a result, debt held by non-financial companies continues to grow relative to GDP. Although GDP can be thought of as the capacity to pay back debt, this is not so trivial of an issue if looked through Minsky’s framework. While this was a problem before COVID, debt has surged as the Federal Reserve and Congress backstopped the market with unconventional methods, saving countless firms from bankruptcy during the pandemic.

In other words, policymakers may have turned our economy into a skyscraper that has difficulty swaying. While this does not mean that investors will suffer if the economy were to hit a rough patch, steps can be taken in order to be better prepared.

Volatility means change. When people refer to market volatility, they are generally referring to downward price movements. But recent action in meme stocks has shown that increased volatility can occur with upward movements in price as well.

Complicating matters further, stability often breeds more volatility. When people think the coast is clear they lever up, leaving them less wiggle room.

This is why many of the institutional alternative investment managers available on our platform invest with an active strategy that keeps volatility in mind.