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.

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