Like Bananas, Big News Comes in Bunches

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.