Market Volatility Resumes Post-Crash Decline

Motley Fool guest contributor Brad Hessel manages an investment advising service in North Carolina. He has previously worked in investment banking, and has founded or co-founded a computer game design company, a CASE tool software company, and a knowledge management consulting practice. 

For anyone concerned about the parallels between the 1929 and 2008 market crashes, the third quarter produced good news: Volatility declined 30% from the second quarter. For the quarter, the average daily change in the value of the S&P 500 index was ±0.78%, as compared to ±1.11% last quarter.

I track market volatility because it is a reasonably reliable gauge of risk levels: 80% of the time from 1950 to 2010, when volatility in the S&P 500 goes up -- that is, the average annual daily change in the price of the index (up or down) is greater than it was in the prior year -- market performance declines. And when volatility declines year over year, market performance improves 63% of the time.

Normally, the market is remarkably stable. Over the long term, the average S&P 500 index move -- either rising or declining -- has been 0.62% each day the market is open. Actually, 52% of the time, the change in the value of the index rounds to 0% (that is, the change is less than one-half of 1%). Another 38% of the time, the change rounds to 1%. Here is an analysis of how much the value of the S&P 500 index has changed each trading day from March 1950 thru the end of September 2010:

Daily Change

Total Days

0% to 0.5% 7,040 (52.28% of the time)
0.5% to 1.5% 5,098 (37.86%)
1.5% to 2.5% 1,002 (7.44%)
2.5% to 3.5% 207 (1.54%)
3.5% to 4.5% 66 (0.49%)
4.5% to 5.5% 27 (0.20%)
5.5% to 6.5% 9 (0.07%)
6.5% to 10% 13 (0.10%)
10%+ 3 (0.02%)

Source: Author calculations.

Just to give an idea of how extreme the volatility in 2008 was, in 60 years of data, there are only three days the market moved ±10% -- two of them were in 2008. There were only 13 days the market moved 6.5% to 10% in either direction; six of those were in 2008. And six of the nine 5.5% to 6.5% days we've experienced since 1950 were in 2008.

1929 was every bit as extreme for the Dow Jones industrial average as 2008 was for the S&P 500. (The S&P 500 was not created until after World War II, which is why we rely on the Dow for the 1929 data.) Following the 1929 crash, volatility immediately declined sharply from the crash peak to a near-normal level in the first quarter of 1930, but then began a jig-jaggy climb that lasted from then until 1932, peaking in that year's third quarter at a level even higher than had been reached in the quarter when the 1929 crash took place. Here's a chart that compares market volatility for the periods around the two crashes:

Source: Author calculations.

Source: Author calculations.

Measured in terms of volatility, the aftermath of the 2008 crash looks less and less like post-1929 with each passing quarter; things are certainly looking up since the last time we reviewed the situation. Until the second quarter of this year, volatility levels had declined for five consecutive quarters since 2008's fourth-quarter spike during the market meltdown.

The nervous Nellies noted how daily volatility spiked 88% sequentially from April to June, but now it's back on the decrease. The latest quarter was the sixth consecutive postcrash quarter in which present-day volatility was lower than it was in the equivalent 1930s quarter, and the sixth out of seven quarters since fall 2008's market meltdown with a sequential decline in volatility.

Of course, volatility is not predictive. That is, frenetic trading does not generate a black swan event; it's the other way round. At any time, one of Europe's PIIGS could get slaughtered, somebody could attack Iran, the Feds could start prosecuting banksters, bad real estate and business loans in China could start causing banks to fail, or any number of other random events could trigger a big percentage down day ... and then we're potentially off to the races again. There is most definitely a higher level of systemic risk out there now than the average level of risk since 1950.

But for now, the collective wisdom of the market is that 2008 was not 1929, and accordingly the odds of a cataclysm, while not reduced to the normal near zero, have shrunk.

Do you think we're on a parallel track toward the Great Depression? Weigh in with your comments below.

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