Maybe investors should be getting more accustomed to out-of-nowhere stock-market plunges akin to those that rippled though markets last week, knocking more than 830 points off the Dow Jones Industrial Average on Wednesday and leaving the blue-chip gauge and the S&P 500 with their worst declines since February.
History also indicates that when they occur, a market bottom usually isn’t too far away.
“If sudden market plunges out of nowhere seem to be happening more frequently than in the past, it’s not just you,” wrote Pravit Chintawongvanich, equity derivatives strategist at Wells Fargo Securities, in a Monday research note.
Such sudden bursts of volatility have become more frequent in the past few years, he said, pointing to the chart below.
The graphic looks at days when the ratio of 5-day to 3-month realized volatility exceeded 3. “In other words, days when there is a huge burst of volatility compared with what’s been the norm,” Chintawongvanich wrote. Since 2007, there have been six such events versus only five in the preceding 50 years. In fact, a 22-year stretch from 1964 to 1986 didn’t see a single one, he noted.
The Oct. 10 selloff saw the S&P 500 SPX, -0.14% fall 3.3%, while the Dow dropped 831.83 points, or 3.2% — the biggest one-day drops for each since Feb. 8.
The striking thing about almost all these events, he noted, is that market bottoms were usually within a few percentage points, producing a small drawdown on average. And in almost every instance, stocks were higher within the following three months.
But it also indicated that things got bumper, he said, with realized volatility typically higher after the event.
Chintawongvanich took a stab at explaining why such eruptions of volatility tend to mark a bottom or at least a near-bottom. He concludes that, most likely, it’s because the downdrafts are more about liquidity — and the temporary lack thereof — than any sudden change in market fundamentals. He writes:
If the market suddenly has a huge selloff out of nowhere, then either 1) the economic fundamentals have instantly changed from yesterday, 2) the market collectively decided stocks are much more risky than they were yesterday, or 3) more liquidity was demanded than the market could provide. It is unlikely 1) fundamentals is the case today—most would agree economic fundamentals haven’t changed from a week ago. 2) higher risk premium could possibly be the case—after all, if 10-year yields are higher, perhaps the equity risk premium should be higher, there are some worries about earnings growth, margins, trade, and so on. But the real reason is probably 3) lack of liquidity, or more specifically that selling because of 1) and 2) led to a problem with 3). At any rate, if stocks are down because more liquidity is demanded than the market can supply, they should go back up once the liquidity demand goes away. That should be true whether the liquidity is demanded by “portfolio insurance”, CTA robots, or good old fashioned human traders.
But why are these events more frequent? Chintawongvanich said it’s possible that market structure has changed. That could come from the demand side, via increasing use of options and related products and strategies, or on the demand side from the rise of high-frequency trading and other developments.
Regardless of the reason, investors can at least take comfort know it isn’t all in their heads.
