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Saturday, 20 March 2010

Volatility, the Last Anomaly

Jitterbugging Markets

As we’ve previously seen many of the strange anomalies that affect investors have a nasty habit of disappearing, just as soon as people recognise that they exist. This wantonly random behaviour gives fuel to the last remaining adherents of the efficient markets hypothesis who can point out that despite the best attempts of behavioural financiers the evidence keeps on vanishing.

Despite the mysterious case of the missing anomalies there’s one that resolutely refuses to go away, squatting in the middle of the markets like a recalcitrant and extremely ugly toad. Rather ungraciously stocks continue to bounce around like a jitterbugger on speed. Regardless of everything else it’s volatility, the last anomaly, that keeps on giving. And then taking away. And then giving back again.

Stuff Happens

High volatility – the nasty habit of share prices to veer about in a sickening rollercoaster fashion rather than trending along near some fundamental value – is a worryingly unpredicted emergent property of markets. Observing the apparently irrational bouncing about of stock valuations one might be tempted to wonder if this is happening less because of the markets adjusting prices due to changes in fundamentals and more, well, because sometimes stuff just happens.

The possibility that prices wander around in a random fashion for no particular reason – rather like the plot of a struggling sci-fi series trying to find a decent dénouement – is enough to give several generations of economists palpitations, not to mention unnerving the serried ranks of financial analysts who could find themselves put out of business by a decent Brownian motion generator such as a nice cup of tea. Under such circumstances they might actually feel better if it turned out that prices move about because people are irrational.

Volatility Rules

As far back as 1981 Robert Shiller pointed out that the fundamental valuation of the S&P500 computed historically – which roughly equates to the value of the index as a discounted stream of future dividends – followed an extremely stable trend. Basically, if you think of markets as efficient their fundamental value looks pretty constant over time. Yet, at one and the same time, the S&P itself wobbled around this stable valuation like a politician trying to avoid a paternity suit. Not unreasonably Shiller pointed out that it rather looked like there was unexplained volatility in the system. Up to thirteen times the expected volatility.

Such is the nature of these things that this sparked off a lot of debate which largely involved a bunch of economists, most of whom can individually start an argument in an otherwise empty room, metaphorically shouting at each other while brandishing large charts covered with hieroglyphics. Yet even while they were doing this markets continued to bound around in an enthusiastic but alarming fashion throughout the nineteen eighties before spectacularly collapsing on Black Friday in 1987 for no reason that anyone can discern with any certainty in hindsight (although lots of people have tried).

Intrinsic Volatility

Indeed, up to the present time, there is no variant of the efficient markets hypothesis – and there are a lot of variants – that can successfully and reasonably explain the excess variation of markets based on discounting the value of future returns. Volatility is the anomaly that simply refuses to go quietly into the good night: to the point where, eventually, a few bright economists wondered if it might not actually be an anomaly at all. What if, in fact, volatility is an intrinsic part of market behaviour?

In fact a proper explanation of volatility would need to somehow encapsulate the fact that it sometimes reverses polarity and goes off in completely the opposite direction from that exhibited previously. Sometimes it completely vanishes, for a while, before pouncing out and savaging investors when they’re not expecting it. All of this implies, of course, that markets suffer from significant periods of over and undervaluation.

Irrational Assumptions

The logic behind the efficient markets position is fairly clear cut. If stupid and irrational investors start to overbid for a stock then clever and rational investors, who recognise that the security is overvalued, will sell it. Although you may see a temporary over or under valuation accompanied by excess volatility eventually prices will come back into equilibrium as the basic laws of supply and demand come into effect.

This argument, of course, has a couple of fundamental flaws. Firstly, it assumes that there are sufficient clever and rational investors willing to balance the stupid and irrational ones – if there ends up being an imbalance between the smart sellers and bozo buyers then you won’t rapidly swing back to an equilibrium point.

Secondly it assumes that clever investors are in a position to take advantage of the errors of the dumb. If you assume that, for whatever reason, a particular stock ends up completely owned by idiots who then proceed to trade amongst themselves then they’ll bid the price up to higher and higher valuations in a toxic game of pass the ticking parcel. In such a runaway feedback situation the basics of valuation would go out of the window.

A One-Way Bet

There are a number of recorded instances where this type of situation appears to have happened. This paper by Eli Ofek and Matthew Richardson records many instances of apparent valuation insanity during the dotcom era including the infamous situation where 3Com sold just 5% of Palm, a manufacturer of handheld computers that the mass of maladjusted mavens loose in the market at that point decided was a sure-fire hit. The frenzy of irrational bidding for these free-float Palm shares was such that the valuation of the 95% of the Palm stock still owned by 3Com exceeded the market valuation of 3Com itself. Yet it was impossible to take advantage of this situation because all of the available Palm stock was owned by excitable, irrational investors.

Ofek and Richardson also suggest another reason for excess volatility – heterogeneity of beliefs amongst investors. Essentially if everyone is captured by the zeitgeist of the moment then the market can only go one way, at least until the bitter reality of negative equity finally strikes home.

There may be another, almost rational, reason why volatility may not easily be put back in its box. Professional investors, incentivised to look for short term gains, will be inclined to ride momentum, buying into stock and market trends, rather than looking to bid against them. With such a short-term outlook this makes sense because momentum tends to hold over shortish periods of up to a year while mean reversion effects apply over longer timescales, often up to three years. If major elements of the investing community aren’t willing to bet against trends on the basis of fundamental valuations then it’s no surprise that volatility can overshoot in either direction.

When Is Smart Too Smart?

In fact it’s probably worse than this, because instead of smart money diminishing the volatility of markets and driving them back towards a fundamental valuation it appears that it often has the opposite effect. De Long, Shliefer, Summers and Waldmann suggest that the really smart money aims to outsmart the irrational, behaviourally compromised investors by buying in ahead of them, aiming to make money by flipping their holdings. So much for efficient markets and the smoothing out of volatility by intelligent investors. Who's smart now, then?

Behavioural economists, of course, don’t find any of this very surprising. People get excited, pay too much for investments and drive them to highs unsustainable by future earnings. Volatility is the outward sign of this and, as such, is a powerful signal for contrarian investors. When the herd is running, run – the other way.


Related Articles: Pricing Anomalies: Now You See Me, Now You Don't, To Predict the Next Bust, Ask an Austrian, Darwin's Stockmarkets

9 comments:

  1. I have a weird theory that volatility is like a Mandelbrot set. If we halved or quartered volatility, we wouldn't notice, because we'd only see the volatility calibrated to the new scale.

    Allied to that, if we get rid of sources of volatility (say a lack of price information) then the remaining sources rise to compensate.

    In short, if the study of markets really was a science like physics etc, there'd probably be some sort of Plancks style constant of volatility, maybe related to how we do maths or maybe our brains.

    Feel free to do a PhD on it but send me the dividends. :)

    ReplyDelete
  2. Indeed, up to the present time, there is no variant of the efficient markets hypothesis – and there are a lot of variants – that can successfully and reasonably explain the excess variation of markets based on discounting the value of future returns.

    I can describe a variant that explains things. The market is efficient but only in the long run (after the passage of about 10 years). Prices are set entirely by investor emotion (which is influenced by economic developments but not necessarily in a rational way) in the short run.

    What if, in fact, volatility is an intrinsic part of market behaviour?

    Volatility would come to an end if we encouraged investors to adjust their stock allocations in response to valuation shifts. That way, each act of irrationality would be countered. There would be price discipline in the market and the market price would go up each year only by the average long-term return amount (6.5 percent real), which is the real addition to value that stock investors see each year.

    Volatility cannot come to an end for so long as many investors (those following Buy-and-Hold strategies) refuse to change their stock allocations in response to valuation shifts. A market in which investors are not willing to keep their risk levels constant is like a car without brakes. It's driven by the Get Rich Quick impulse (investors who enjoy seeing big numbers on their portfolio statements continue to bid prices upward and there is no restraint on them doing so).

    If we encouraged investors to take valuations into consideration, volatility would pretty much disappear. And that means that risk would disappear too. Owning an index fund would be like owning a share in U.S. productivity. No bull markets. No bear markets. All the craziness that characterizes stock investing today would be eliminated.

    Sign me up!

    Rob

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  3. Mr. Bennett,

    You are spot on about integrating some type of valuation filter to one's stock allocation. Astute investors have incorporated some type of "valuation timing" into their investment decisions since the beginning of time. Even with the great potential to enhance risk-adjusted returns it is far from a sure thing at the end of the day. What you are really stomping your foot about is a desire to smooth everybody's equity curve. This is a noble effort that will add value to most investor's portfolio, even if somewhat poorly executed. Beyond that, the bulk of the rest of your thesis falls significantly short of the smell test. In fact, I would argue you have it largely backwards. I believe you greatly over exaggerate the number of investors who buy and hold. In fact, the research routinely done by Dalbar, Morningstar's publishing of investor returns, and the academic behavior research literature shows they do exactly the opposite of what you claim they do. Of course there are many investors who simply buy and hold but their numbers are much smaller than you believe. The gross over valuation you despite, and rightfully so, are not caused by the buy and holders, but by the non-buy and holders. One could argue that we could reach your vision of investment nirvana by encouraging more buy and hold, not less. As much as buy and hold appears to be an act of insanity, I would bet that empirically it holds up pretty well, even if held against many types of value timing models. I believe Mr. Bogle and his ilk advocate buy and hold, not because they don't realize the potential for large draw downs, but rather if practiced; over time, it holds up rather well as "doing the least amount of damage." And I am not a buy and hold advocate. Finally, the assertion that if every global investor prayed at the alter of stock allocation via a valuation signal that volatility would magically disappear I find to be contrary to everything that is known about man since he existed.

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  4. "a particular stock ends up completely owned by idiots who then proceed to trade amongst themselves then they’ll bid the price up to higher and higher valuations in a toxic game of pass the ticking parcel"

    This, of course, is exactly the behaviour most awarded amongst professional traders.

    ReplyDelete
  5. "Indeed, up to the present time, there is no variant of the efficient markets hypothesis – and there are a lot of variants – that can successfully and reasonably explain the excess variation of markets based on discounting the value of future returns."

    You are misinterpreting the EMH. The EMH does not say that volatility will never be high. It only says that stock prices incorporate all public information. That's it. The key point is that you cannot outperform the market by studying past price behavior or balance sheets of a bunch of stocks. Again, do not jump to false conclusions here. Obviously chance and uncertainty exist in life, so of course there are going to be millions of instances when someone beats the market, but that could be due to luck (throwing darts) or more importantly, taking higher risk, and you have to consider those who don't beat the market. And it is certainly possible, in fact statistically very probable, that there will be a few investors who consistently beat the market year in and year out.

    And, yeah, not so sure about the "discounting the value of future returns." I mean, that's what a company is worth. The EMH merely says that investors will base their estimates of future cash flows based on all available public information.

    If you don't buy the whole EMH thing, it's really not that big of a deal. By all means, start digging through some 10-Ks--it's only a matter of time before you find some info that hundreds of millions of investors missed and get rich. I would go all out--it's free money. Implement some strategies, like momentum. I mean, why would you not invest on momentum? Clearly, it's a wining strategy--plus, the market is inefficient, so you don't have to worry about a bunch of "rational" humans copying your momentum strategy and driving up the prices of your momentum stocks.

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  6. Gary L. Kaplan5 April 2010 at 11:41

    I have been reading a great deal on the failure of Economists and Econophysics and I'm amazed that almost no one, other then Didier Sornette knows anything about the Elliott Wave Theory. It explains the the market fluctuations are based on fluctuations in investor mood, endogenous. The news follows social mood shifts, not causing them.

    I'm also amazed at how many otherwise smart people believe all or part of The Efficient Market Hypothesis. A little research will find that it has long been declared dead and now exists as a Zombie Theory. Behavioral economist, James Monitor has called the EMH " Deader then Monty Python's parrot". Yet it is still here wasting every ones time.
    I would to see someone take all the current Economic Theories, separate out the ones that have failed to predict any thing and see what is left.
    Unknown to academia The Elliott Wave Theory has passed the test of time and money. Around sine 1938 the largest firm selling financial forecast in every market uses the Wave Theory. The theory is tested every day by people trading money in the markets. A predictions are made, people buy them, trade the markets and comeback the next month. What other theory works so that people will buy the predictions?
    Mandelbout plagiarized Elliott and I have yet to see Eugene Stanley give credit for the ideas that the markets are scale independent and universal. The crux of the problem is that for anyone in academia to acknowledge Elliott, they would have to admit that they have been too long and too much wrong.

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  7. The explanation: low equity volatility means that people can get an above-average return through levered equity investments. In the very long run, this must stop working--which it does, because this leverage creates overvaluation and itchy trigger-fingers.

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  8. I feel that the volatility of markets is solely down to fear and greed.

    It is irrational that a stock can be up 5% one day down 3% the next then up 7%.

    These are company valuations. Business is long term how can the companies be worth such different amounts each day?

    ReplyDelete
  9. If you don't buy the whole EMH thing, it's really not that big of a deal. By all means, start digging through some 10-Ks--it's only a matter of time before you find some info that hundreds of millions of investors missed and get rich. I would go all out--it's free money. Implement some strategies, like momentum. I mean, why would you not invest on momentum? Clearly, it's a wining strategy--plus, the market is inefficient, so you don't have to worry about a bunch of "rational" humans copying your momentum strategy and driving up the prices of your momentum stocks.

    ReplyDelete