This season's stock-market mystery is: The Case of the Declining Volatility. Volatility—the degree to which stocks move in any particular direction—is strangely absent on Wall Street. The Dow Jones Industrial Average closed the year down 0.61 percent, the smallest annual movement since 1926, and just one of four years in which it moved less than 1 percent in any direction on the year.
On a day-to-day basis, the markets are also less volatile. In his year-end column, Floyd Norris of the New York Times wrote that "from 2000 to 2002, the Standard & Poor's 500 showed a daily gain or loss of at least 1 percent for two days a week or more." But, he noted, volatility has fallen sharply since then. In 2002, the S&P 500 moved 2 percent or more in a single day 52 times. That didn't happen once in either 2004 or 2005. According to the VIX Index, which is traded on the Chicago Board Options Exchange and is regarded by professionals as the single best gauge of investor sentiment on market volatility, the price of insuring against volatility has been declining for several years. Meanwhile, hedge funds, which thrive on volatility, had a lame year in 2005 precisely because of the decline in the number of manic episodes.
What's this all about? After all, the world is arguably more volatile than ever. There's instability in Iraq and Venezuela, famine in Africa, and tensions in the former Soviet bloc. With periodic corporate implosions like Refco and slow-motion disasters like Delphi, the process of creative destruction is proceeding apace.
One theory is that declining volatility is simply in hibernation. Now that investors have collectively grown complacent about volatility, it's poised to rise up and punish—or reward—them (indeed, today the stock markets were quite volatile). But it's possible that things really are different, and that this is a prolonged era of lower stock volatility. Why? There have been some significant structural changes in our economy. We have greater transparency in accounting, better corporate governance (spurred in part by Sarbanes-Oxley), a global savings glut, and the proliferation of investors seeking to mine the slightest market inefficiencies for profits. These are all volatility-decreasing developments. It's possible that the markets, while nowhere near entirely efficient and rational, are much more efficient and rational than they used to be.
Stock prices, and the prices of other assets, are a vehicle through which information, performance, expectations, fear, hope, and hype get incorporated into hard numbers. Bubbles form in particular sectors—or in entire markets, as was the case in the 1990s—when sentiment is overwhelmingly hopeful and when hype crowds out fear. Later, when new information and fear belatedly get factored into stock prices, bubbles deflate.
But these days, information, fear, hype, and data get translated into stock prices much more quickly and effectively than they did in the 1990s. And thanks to the scar tissue from the 1990s bubble, investors have become somewhat inured to hype. As a result, they anticipate and discount the effects of booms and busts long before they actually materialize.
Consider oil and housing, two sectors in which people have blithely spoken about bubbles forming. Here's a one-year chart of ExxonMobil. In 2005, oil prices rose 40 percent, but ExxonMobil's stock was up only about 11 percent. Clearly investors are not simply extrapolating another 40 percent increase in the price of crude for 2006. Look at this one-year chart of high-end home builder Toll Brothers, which peaked last summer when housing numbers were still strong. Clearly investors were anticipating a slowdown in the red-hot housing market, which may finally be coming. In both instances, nervous traders and stockholders started ratcheting down their expectations for future profits long before the companies did.
It also seems that companies—and not just investors—have a better handle on their near-term prospects than they did in the 1990s, when technology companies like Cisco (wrongly) claimed they had near-perfect instantaneous information on their markets, customers, and suppliers. In 2000 and 2001, many technology companies kept on running full out, not realizing their market had collapsed—like the coyote running off the cliff.
That tends to happen less frequently now. Thanks to IT and to more effective logistics and supply chains, companies have much better market intelligence than they did several years ago. That's not to say companies aren't caught short and don't report disappointing earnings—which causes stocks to be volatile and spurs investors to sue management. It just happens less frequently. This new study by Cornerstone Research shows that securities class actions fell 17 percent in 2005. More significant, alleged investor losses claimed by such suits fell 33 percent on the year.
Finally, the rise in liquidity—lots of money from all over the world being put to work in the markets every day—may also counterintuitively contribute to reduced volatility. Many traders today rely on proprietary algorithms, software, or systems that dictate rapid-fire trades depending on market action. Every time Wal-Mart dips below 47, it might simultaneously trigger a sell order at 30 or 40 trading desks and trigger a buy order at another 30 or 40 trading desks. The net effect is like two tennis players volleying to each other from a step behind the net. The ball bounces rapidly in a confined space and ends up moving not very far at all.