Writing for the New York Times, Louise Story and Graham Bowley note that large market swings are becoming a lot more common than they used to be.  (See “Market Swings are Becoming New Standard”)

“It has become more likely for stock prices to make large swings—on the order of 3 percent or 4 percent—than it has been in any other time in recent stock market history,” write Story and Bowley, referring to NY Times analysis of daily stock price changes going back to 1962.

But while volatility has certainly ticked up in recent years—and particularly in the last month—there is very little new under the sun.  Markets tend to go through long periods of relative calm interrupted by violent outbreaks of volatility that can last from a couple days to a couple years.

Consider Figure 1, which shows the daily price changes of the Dow Jones Industrial Average ($DJIA).  A couple things immediately jump off the page.  The first is the 1987 stock market crash, caused by “portfolio insurance” programs run amok.  But ignoring 1987, we see something that looks a little like a barbell.

Figure 1

Volatility was high in the late 1920s and throughout the Great Depression decade of the 1930s before entering nearly four decades of relative calm.  Stocks got a little more volatile in the 1980s, returned to relative calm for much of the 1990s, and then all hell broke loose.

There was a surge in volatility during the late 1990s that coincided first with the Long-Term Capital Management meltdown and then the dot-com bust and the fallout from the September 11, 2001 terror attacks.  Volatility died down a bit during the mid-2000s…and then exploded as the mortgage crisis struck.

Pondering Von Mises, no doubt

Today, there is a lot of figure-pointing as to whom or what is responsible for the uptick in volatility.  Austrian economists—who have enjoyed a high profile after Tea Party presidential candidate Michele Bachmann recently remarked that she read Von Mises on her beach vacations—might argue that excess liquidity and ultra-loose Fed policy are to blame.  There is certainly some amount of truth to this.  The liquidity provided by the Fed has a way of seeping into the financial markets, where it can play the role of gasoline poured liberally onto a bonfire.  But liquidity alone cannot explain the roller coaster ride of recent years.

In the New York Times article, Story and Bowley suggest that high-frequency trading and the proliferation of new exchange-traded funds (ETFs) are to blame.

The “high-frequency trader” has grown into an almost mythical boogeyman in recent years and particularly after the May 2010 Flash Crash, in which the Dow dropped 1,000 points within minutes and then gained most of it back—within minutes.

High-speed quantitative traders are nothing new, of course.  But in recent years, they have come to control as much as 60% of daily trading volume, which is fine—except when they all vanish at once and cause liquidity to disappear, as they did during the Flash Crash.   To this day, there has never been an adequate explanation for what “caused” the Flash Crash, and that is unfortunate because that event—even more than the post-2008 bailouts—proved to many investors that they are indeed playing a game that is rigged against them.

Given the size and liquidity of global stock markets, I remain skeptical about the effects that ETFs are having on volatility.  But the commodities markets are an entirely different story.  The havoc that commodity ETFs are wreaking on metals, energy and materials prices is a topic I have covered recently in Sizemore Insights (see “The Myth of Commodities Investment.”)

The commodities markets have fallen victim to “financialization.” It is the capital markets—composed of everyone from multi-billion-dollar hedge fund traders to do-it-yourself individual investors—that now set prices and not the supply and demand dynamics of real producers and consumers. This renders the all-important price signals all but meaningless. Producers are thus left to “guestimate” what real demand is and adjust their production accordingly.

Edward Hadas recently recounted a joke told by disenchanted Soviet era economists that I think is appropriate:

Soviet patriot: “The USSR will invade and conquer every country in the world, except New Zealand.”
 
Curious observer: “Why leave New Zealand out of the global communist economy?”
 
Patriot: “So we can find out the market price of goods.”  (To view Hadas’ full article, follow this link.)

Lenin and Stalin must be laughing at us from hell right now. The West might have won the Cold War, but Soviet-style central planning has become the de facto method of setting commodity production because the capitalist system has become perverted beyond all recognition by its own capital markets.

What are we to take away from all of this?  Will volatility be “permanently” higher, as Story and Bowley suggest?

History suggests that this too shall pass.  Markets have a way of adapting, eventually, and I see no reason why this time is different.  Still, this doesn’t mean that the volatility cannot persist for months or even years.

While it’s difficult to invest with confidence in this kind of market, investors can use the volatility as an opportunity.  Investors that keep a little cash in reserve can use the violent downdrafts in the market to accumulate shares of high-quality, dividend-paying companies—the kinds of businesses that will survive and thrive in any economic conditions (see “Wintel: The Ugly Sister and the Buy of the Decade”).

For investors with a long time horizon and a healthy amount of emotional detachment, volatility is nothing to be afraid of.  We should consider those immortal worlds of Warren Buffett: “Be greedy when others are fearful and fearful when others are greedy.”

Given the fear out there, I would say a little greed is in order.

Related Post: Risk, Return, and Reality Revisited

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