Dispelling a Myth About Stock Market Volatility

(Bloomberg View) -- During the recent spate of concern that stock market volatility was too low, I heard an old myth. For example, former Treasury Secretary Larry Summers explained that the phenomenon was a natural consequence of stock market gains:

The volatility of the market moves very much with the level of the market. The reason is that if a company has $100 of debt and $100 of equity, and then the stock market goes up, it's 50/50 levered. If the stock market goes up by $100, then it has $100 of debt and $200 of equity and it's only one-third levered. So when the stock market goes up, its volatility naturally goes down.

The following rebuttal is not intended to pick on ivory tower economics or Summers, but rather to expose important misunderstandings that fool even some practicing investors.

To begin with, the quote is a bit garbled. The company has 200 percent leverage before (not after) the market goes up, $200 of assets and $100 of equity. Afterward it has 150 percent market value leverage.

But it is empirically false that the market is less volatile after positive returns. The effect should be strongest at short intervals, because companies might restore their pre-increase debt ratios  over longer intervals. The graph below shows the annualized S&P 500 volatility the day after price movements of various sizes.

As any practitioner knows, the more the market moves today, the more volatile it is likely to be tomorrow. The volatility persistence effect is a bit lower if you look at S&P 500 returns over the previous month, as in this chart:

Summers may have meant that volatility persistence is the primary effect, but is muted by the leverage effect: that the increase in volatility after big down moves is larger than the increase in volatility after big up moves. That empirical effect is real, but leverage is not the explanation. Moreover, it was not a reason to expect lower than normal volatility after a run-up in the S&P 500, just lower volatility than you would expect after a market decline of the same size.

One obvious flaw in the leverage argument is that companies have assets as well as liabilities. S&P 500 companies,  for example, have about $30 in cash for every $100 in debt. And almost all the tangible assets on corporate balance sheets -- real estate, inventory, trucks and computers -- have values far less volatile than the equity.

Suppose Summers' example company had $150 of tangible assets. Before the stock market run-up, it had $50 of tangible net assets  and $50 of intangible going-concern value. After the run-up it still has $50 of tangible net assets with stable value, but $150 of intangible value based on volatile long-term expectations of future growth.

But the biggest problem with the myth is the dangerous bubble premise that the higher prices go, the more stable they are. As equity prices go farther beyond tangible net assets and predictable earnings flow, relying more on assumptions of future growth, the market is more risky, not less. Its valuations are based on less-certain factors, and it has farther to fall if assumptions change.

I think the reason the myth is popular among economists insulated from markets is that they assume anything that reduces leverage, even a bubble, reduces risk. This is one reason regulators seek risk in the wrong places: They look where prices have fallen and apparent leverage is high; while the risk is mostly where prices have risen and apparent leverage is low.

The healthiest markets have volatility commensurate with genuine economic uncertainty, neither panic nor obliviousness to risk. Big market moves should be based on real economic factors, and thus should be accompanied by increased volatility. If they are not, it's not necessarily a bad thing, but it's something to be investigated, not waved away.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street."

1. https://medium.com/conversations-with-tyler/tyler-cowen-larry-summers-blog-secular-stagnation-twitter-421a69ed84c8

2. In fact, corporate debt-to-market value of equity ratios increased over the period in which the S&P500 had gone up, contradicting Summers' model.

3. Excluding financials which have complicated balance sheets not well-modeled by this kind of reasoning.

4. Tangible assets minus liabilities.

To contact the author of this story: Aaron Brown at aaron.brown@privateeram.com.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.

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