One of the most prominent features of the U.S. economy in the last two decades has been a consistent decline in volatility. This observation doesn’t apply just to the stock market, as volatility in earnings, production, and even macroeconomic growth has decreased significantly since the mid-1980s. Recent volatility, however, points to a potential increase of the metric to more historical levels.

So-called “news” volatility, which measures the response of markets to changes in the economy, rose dramatically in the third quarter. Concerns over the corporate debt and subprime mortgage markets were catalysts for extreme moves in the short end of the yield curve. Price movements in Treasury bills hit levels not seen since 1987, with yields dropping 54 basis points on August 28th alone. Moves in the stock market were no less impressive, as the S&P 500 index fell nearly 9% from July 20 to August 16 before finally recovering.

A closer look at equity market volatility highlights this recent increase, as the number of days with price changes that exceed three standard deviations occurred with much more frequency that one would expect. Further, the numbers of large drops in prices seem to be increasing more than the number of large price gains.

There are several potential reasons why volatility is increasing. Some researchers believe that the distribution of returns is so far askew from what would be expected from statistical theory that well-known metrics such as standard deviation and average daily return is not sufficient to describe the type of behavior that is likely to be observed in the capital markets.

Another theory is that volatility is exhibiting a type of behavior known as “clustering,” where large changes in price are followed by further large changes. This would effectively skew volatility higher, allowing for significant overall increases in market volatility, in a relatively short amount of time. Indeed, the 55% year-to-date increase in the VIX, a well-known gauge of stock market volatility, is largely due to the dramatic intra-day volatility witnessed in the third quarter.

Looking across longer timeframes can change one’s viewpoint. If one considers volatility over the last four years, the market moves seen in the last three months are not as dramatic as they might seem. This indicates that market volatility is returning to more normal levels rather than expanding into unexplored territory. Clustering theory suggests that volatility could markedly increase, reversing a years-long tendency of declines.

The Monthly Index Report for September 2007

Index

Sep-07

QTD

YTD

Description
S&P 500 Index* 3.58%

1.56%

7.65%

Large-cap stocks
DJIA*

4.03%

3.62%

11.49%

Large-cap stocks
Nasdaq Comp.*

4.05%

3.78%

11.58%

Large-cap tech stocks
Russell 1000 Growth

4.19%

4.21%

12.68%

Large-cap growth stocks
Russell 1000 Value

3.43%

-0.24%

5.97%

Large-cap value stocks
Russell 2000 Growth

2.91%

0.03%

9.35%

Small-cap growth stocks
Russell 2000 Value

0.45%

-6.26%

-2.70%

Small-cap value stocks
EAFE

5.37%

2.23%

13.57%

Europe, Australasia & Far East Index
Lehman Aggregate 0.76%

2.85%

3.85%

U.S. Government Bonds
Lehman High Yield

2.62%

0.33%

3.21%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

3.89%

-2.40% 4.13% Managed Futures
3-mo. Treasury Bill*** 0.36% 1.24%

4.01%

All returns are estimates as of September 28, 2007. *Return numbers do not include dividends.

** Returns are estimates as of September 27, 2007. *** Returns are estimates as of September 25, 2007

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.