Asymmetrical Information

From the desk of Mindles H. Dreck:

Volatility Achievement

Holman Jenkins, in an otherwise sound column pointing out that corporate scoundrels are not new to the U.S., observes:

In the markets, the most visible trend has been toward more and better information, analyzed more intelligently, with a resultant decline in the volatility of stock prices.

The rest of the article is on point, and yet that statement, which formed the pullquote in the print version, is dead wrong. For starters, market volatility is up over the long term, but therein lies a tale.

In the late 1980s and early 1990s, the economy absorbed the savings & loan crisis, suffering a mild recession in 1991 but recovering to strong growth before the year was over. Specific fallout was severe - you could see through the skyscrapers in several cities in the South and West of the country, and hundreds of banking institutions failed. Pundits pointed to the S&L crisis and made bland overreaching pronouncements about business ethics and the evils of deregulation (in fact, as in California's energy problem, partial deregulation created a massive trap), but the job and market losses were soon absorbed by other sectors of the economy. Institutions like GE went bottom-fishing in thrift-distressed real estate and made a killing.

1994 was an interesting year in the stock market. The S&P500 was down 0.5% (price only). Underneath the calm surface, however, was a riptide. By the end of the year half the stocks on the New York Stock Exchange were 40% off their 52-week highs. Several hedge funds went "belly up", mostly those selling interest rate volatility in one form or another, such as David Askin's. Pundits pointed to the crisis and made bland overreaching pronouncements about business ethics and the evils of speculation....

In 1998, Russia defaulted on its debt and Long Term Capital failed. The S&P 500 appreciated about 26%. Pundits pointed to the crisis and made bland overreaching pronouncements about business ethics and the evils of speculation....

Accounting irregularities and company failures cropped up throughout the entire period. The 2000-2001 capital spending bust aggravated the problem, piercing bubbles in telecom and internet-related stocks. Pundits pointed to the crisis and made bland overreaching pronouncements about business ethics and the evils of speculation and deregulation...

Trailing 5-year percentage volatility in the S&P 500, as indicated in the graph linked above, is around 17-18%. This is above 1950-1960 levels, but commensurate with levels since then. Much like 1994, however, the index masks much higher levels of volatility in economic sectors and individual stocks. For instance, volatility over both shorter and longer term time frames has been higher than the broad index in every sector of the S&P (i.e. energy, information technology, etc.) apart from consumer staples and health care. Information technology exhibits more than double the volatility of the S&P 500. Subsectors and individual stocks are even more volatile. The insurance subsector has shown volatility of about 76% over the last three years. Citibank's common stock volatility runs about 32%. As Jenkins says to conclude his article:

No amount of rule tinkering will prevent a Kozlowski or Enron from discovering new ways to blow themselves up. Investors who find this thought unduly scary haven't figured out the oldest rule in the book: You can never be too skeptical or too diversified.

A similar phenomenon exists in the broader economy. In this case personal income and GDP are actually much less volatile than in the past..

...but their constituent parts, regional economies and sectors of the economy, can be much more volatile. There is micro-volatility but macro-stability. Instead of general brown-outs, we get rolling black-outs. These rapid adjustments, and the market and job losses brought about by the Andersen, Enron and Tyco scandals are part of a free market economy healing itself. The specific, wrenching dislocation they cause is part of a process that actually reduces risk to the economy as a whole.

In another time, the combined shock of September 11 and the capital spending bust would bring the whole economy to a halt. Time was, if your local manufacturing company wasn't hiring, there weren't any jobs in your town. Today's economy seems to absorb its pain faster and more dramatically, but isolate the shock to the sector in question. Mobility of capital and labor and a lower dependence on asset-intensive manufacturing industries are at least partly responsible for this change.

So why is market volatility higher than 40 years ago?

Some of the acute, localized volatility as a positive sign of economic adaptability, kind of "good" volatility or Schumpeter's "creative destruction". In stabilizing broad measures of economic volatility, it serves to decrease exogenous risk in the markets and the economy. However, we also see a measurable increase in endogenous risk in financial markets. Keynes called this bad risk "animal spirits", and it is the stuff bubbles are made of.

So, while Jenkins is correct about the lower risk he perceived because of our system's ability to absorb and adapt, and the lower fundamental risk to the market, he is wrong about the total market risk, which has not decreased meaningfully, and has increased over the longer run.

A professor at Stanford has put forth a brilliant theory quantifying the growth in market "animal spirits" in a market general equilibrium theory called "Rational Beliefs". Economists I admire have suggested that RB is to current market theory as quantum physics is to Newtonian physics.

I hope to discuss this, and speculate as to whether this increased endogenous risk is evident anywhere in the economy (I'm afraid labor markets may be a case in point) in a future post. At which time you will all be sleeping soundly or checking out the latest pics over at unablogger. It takes more than a handy Bloomberg to check those curves.

Posted by Mindles H. Dreck at June 12, 2002 10:11 PM | Technorati inbound links