Why remained volatility so low (theory of Woody Brock)

Equities in the world react since the credit crisis (the period of the Great Moderation has ended) more violent on economic surprises than before (the red line in the chart fluctuated before the crisis more compared to the S&P, afterwards it is in line according to the chart of economic surprises in the G10 versus the three month change of the world equity index from MS.


The last few years the volatility moves with the economic news, but not extra. One should expect that because of the euro crisis especially the last year the S&P should have moved much more than on macro news alone.

Why is it that the S&P only seems to react on macro economic news and not at all seems to suffer from contagion from the euro crisis? What is Woody’s theory?

We are used now to the fact that equities fluctuate much more than alone can be attributed to news about fundamentals. Shiller has found already quite some time ago that 80% of the fluctuations of equity prices cannot be explained by underlying news about the fundamentals.

There has been a lot of research why equities move so much more than fundamentals indicate. In the efficiente market theory this was a conundrum: everybody knows everything and has the same rational expectations. Why then all that volatility?

First one tried to find an answer with Behavioral Finance, but that didn’t offer a satisfactory explanation.
Arrow/Kurz had a better theory: it is all about changes in the belief structures. When everybody has different beliefs (expectations) then people will trade a lot. Especially with lots of leverage and strong beliefs you will see plenty of trading. So doing Kurz could explain more than 90% of the volatility.

Price changes are caused by corrections on mistakes, wrong correlated beliefs. In some periods one sees strongly correlated beliefs. Then everybody will be right or wrong. When you were wrong there were massive price reactions (for example the housing market after 2006, nobody believed prices could decline, almost nobody saw the credit crisis coming).

Last year we saw a lack of conviction in the beliefs, there was almost no leverage on the bets. Everybody was wrong in all directions (not in one direction). The beliefs were uncorrelated (there were the most diverging stories ever over deflation or hyperinflation arriving). This caused quite orderly declines and rises of the equity markets. It was only the economic news that did all the job to move the prices.

In sentiment surveys you see now there are not many bulls and bears, but an exceptional amount of advisors that don’t know (they see not big moves, only a correction). So there is a lack of conviction in the forecasts for the markets, there are no strong beliefs and the beliefs are also uncorrelated. There is also less leverage. So it is understandable that equities only react on news about fundamentals and don’t show high volatility.

This is a plausible theory, but difficult to support with empirics. An old theory is saying that when central bank liquidity is high volatility is going down to low levels. That also explains why volatility is not high, even when people are now forecasting euromageddon and taxmageddon.
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The chart above makes plausible that the euro crisis easily could have led to more volatility (stress leads to volatility and stress is what you see in the interest rate differentials between Germany and Italy.

The chart above shows the number of advisors that say they don’t know and the volatility of options (VIX) corrected for realised volatility. There is a relation, but it is difficult to show.

The chart above shows the realised volatility of 30 year Treasuries and the S&P. In most periods equities are more volatile, but there were for periods in which bonds were more volatile. It looks like the euro crisis caused more volatility in US Treasuries.


It is hard to say what the investor should do, it looks like equities are becoming more dangerous and bonds maybe less volatile (but who buys now Treasuries has a high probability of making losses in the coming years).