The Economist's Buttonwood Tree is worried that markets think the future is more predictable than it is:
Economist.com | Volatility: "THERE are few beasts in the financial jungle more curious than the market in uncertainty. Traders buy and sell uncertainty as readily as if it were something tangible, like pork bellies or Treasury bonds. Strange though it may seem, it is no exaggeration to say that the price of just about every risky asset in the world depends in part on investors' perceptions about the price of uncertainty. It is precisely because investors appear so certain about the future that the prices of so many assets are now so high. The opposite holds too, of course. If investors became less certain, those prices would fall.
In financial markets, uncertainty goes under the name of volatility—how much asset prices are moving around. One popular measure of stockmarket volatility, the Chicago Board Options Exchange's VIX index, has fallen to its lowest since 1996 (see chart). In August 2002, it soared to 45; this year it has mostly traded between 14 and 16. Interest-rate volatility has also fallen sharply, though not as far.
What most concerns traders and investors is not how much assets have moved in the past, but how much they are expected to do so. In the jargon, this is called implied volatility. It is the number that traders plug into the models they use to price options: the VIX, for example, is an index of implied volatility of options on America's S&P 500 stockmarket index. Lately, investors in risky assets of all sorts have been selling options. Whether they think of it this way or not, they have been selling volatility too....
The question, of course, is whether the price of uncertainty, particularly in equity markets, will remain as low as it is now. Markets have become less volatile than they were between the spring of 2000 and the autumn of 2002. Moreover, firms in many countries, particularly America, are swimming in record profits, and the longer the global recovery continues, the more convinced investors become that the good times will continue. Both make for more certain share prices. But the steep fall in implied volatility is nonetheless a bit odd. There are, after all, many things that could go wrong for financial markets: tensions are still bad in the Middle East; the oil price is again over $40; and the Federal Reserve is raising interest rates when American households are more indebted than they have ever been....
I'm with the market on this one. Productivity growth worldwide is very strong. If Al Qaeda could destabilize the world, it would have already. And the Federal Reserve is not stupid.
Posted by DeLong at July 27, 2004 12:19 PM | TrackBack | | Other weblogs commenting on this postHowever, the Bush administration is frequently stupid, highly corrupt (in a short-sighted manner) and doesn't mind destabilizing the world. And it is Al Qaeda's biggest recruitment asset.
Posted by: Barry on July 27, 2004 01:10 PMI've been wanting to ask...
I know that productivity growth is supposed to be a Good Thing, but is it in every case? Pardon me for being glib, but it seems to be that the weak economy is prompting businesses to lay off as many people as they can, then work the dog poo out of everybody they still have. That's certainly my personal experience.
And...
I have theory about why productivity has grown faster under Bush than during the Clinton boom: With the markets doing reliably well and interest rates being kept relatively high by the Fed, investments in productivity improvements were less attractive than strictly financial investments during the boom. After the crash of 2001, markets were unreliable enough to force some capital back into productivity improvements, especially given the need among employers to downsize.
So, productivity gains could be a symtom of a damaged economy, one that will largely evaporate when (or if) the economy improves. They're not a product of positive economic developments, and they're certainly not something the Bush administration deserves kudos for.
Posted by: Tom Marney on July 27, 2004 04:07 PM
Yes, the Fed is not stupid but that doesn't mean that without political coordination that they had a real option other than playing a delaying tactic that would eventually get called due.
Posted by: Oldman on July 27, 2004 08:13 PM“If Al Qaeda could destabilize the world, it would have already.” Maybe. But our tactical studies mustn’t assume it.
And the Federal Reserve is not stupid. But Greenspan’s support for hiking payroll taxes to cover Social Security in the Reagan Administration will become, for his own purposes, a fatal error.
On the other hand, them markets shurrre could get jitterbuggy...if they thought we-all might figure-out that a massive redistribution of money to the lower half of the U.S. would improve both consumption and savings, fund investment and capital development, and otherwise make the economy perk along quite zestily, thaank you, as if nothing much really happened!
Posted by: Lee A. on July 27, 2004 09:12 PM“If Al Qaeda could destabilize the world, it would have already.”
So what Brad? This seems nonsensical to me (and is once more a manifestation of economist' arrogance).
Till exactly today, AQ didn´t destabilize because till exactly today it - maybe - couldn't. We aren´t warranted to infer that it cannot destabilize tomorrow.
Listing productivity, al-Qaeda's lack of potency and the Fed as reasons to sell volatility in the stock market seems to miss some other issues. It is specifically uncertainty about stock prices that is being marked down, rather than uncertainty about the world, or general well-being or the course of the US economy. VIX sellers need only worry about being compelled to cough up more money to buyers of VIX contracts than was made in selling the contract. Because there are more longs than shorts in the stock market, implied volatility tends to rise most when stock prices fall (historic volatility, which tends to figure into volatility pricing models, goes up when prices move strongly in either direction). So we aren't really talking about a productivity/terrorism/fed dominated market. The S&P has been trading in a broad range all this year, which has helped bring historic volatility down. Sellers of the VIX (mostly hedge funds, I'm told) have sold the VIX at low implied volatility because their models say its OK. These model things work out fine as long as the assumptions built into the model work out. (Take the notion that a divergence in the price of two off-the-run bonds represents an unambiguous opportunity to make money by playing the spread with massive leverage, for instance. That was the main LTCM oopsie, wasn't it?) A wild guess is that the S&P around 1050 (a nice round number that hasn't trade since November) would mean some of those contract would start to cost the seller money.
Posted by: kharris on July 28, 2004 07:15 PM
"If Al Qaeda could destabilize the world, it would have already. And the Federal Reserve is not stupid."
Yeah, and Deepak Chopra believes in quantum healing. Geez, Delong, I can't you said something so utterly silly.
Posted by: CSTAR on July 28, 2004 09:38 PMCould someone write a letter to the Economist reminding them that it is also volatility if markets go *up* suddenly? I'd do it myself, but after writing no fewer than four letters to them over the last five years pointing out that the Big Mac is not a homogeneous product worldwide (it differs from place to place in fat content, calorific value and even weight; Nick Leeson used to claim to be able to identify different Asian countries' versions of the Big Mac in a blind tasting), I am somewhat demoralised.
Posted by: dsquared on July 29, 2004 04:03 AMFor a longer, somewhat mathematically challenging view of the volatility question and what it implies for the markets, and those who trade in them, check out this guy.
Posted by: Arnold Williams on July 30, 2004 05:17 PMlink didn't post.
Try this:
http://www.fooledbyrandomness.com/
Posted by: Arnold Williams on July 30, 2004 05:22 PM