Stocks are experiencing extreme volatility
One might perceive the recent market activity as uneventful by focusing on the small daily fluctuations in the S&P 500. There has been no significant movement of 2% since February, and the VIX gauge, which measures expected volatility, has only slightly increased from its post-pandemic low reached last month.
Beneath the tranquil exterior, there is a flurry of activity. It is a rare occurrence for stocks to experience such significant fluctuations while the overall market remains relatively calm, as has been the case only once in the past 25 years. Traders in the options markets are making predictions about its ongoing trajectory. The prices of stocks have experienced significant fluctuations, which is quite unusual given the overall stability of the S&P 500 over the past decade.
From an economic perspective, it can be observed that investors perceive a lack of significant activity. However, when analyzing specific stocks, the influence of the dual-speed economy and the enthusiasm surrounding artificial intelligence becomes significantly significant. There has been a significant increase in the number of stocks experiencing 10% swings in a single day over the past three months, compared to other periods where the market’s average move barely reaches 0.5%.
Investors generally believe that the period of high inflation has come to an end, and that the economy will remain stable enough that the Federal Reserve won’t need to make significant adjustments. Additionally, there is a consensus that the conflicts in the Middle East and Ukraine are under control.
“The current consensus among investors is particularly robust, with much discussion centered around topics such as the potential inflation rate, whether it will be 0.3% or 0.4%.” Guy Miller, the chief market strategist at Zurich Insurance, stated.
Of course, the S&P remains calm and steady. Meanwhile, investors are attempting to identify the companies that will thrive or falter due to the prolonged period of higher interest rates and the rise of artificial intelligence. There is a sufficient number of stocks that are influenced by interest rates, causing significant fluctuations in share prices. However, these effects tend to balance out when considering the overall index. These stock options are priced with a remarkably low correlation between them, the lowest we’ve seen since at least 2006.
When it comes to AI, the focus is currently on identifying the potential winners, while the losers have yet to reveal themselves with concrete evidence. However, the optimism surrounding AI has resulted in significant profits for the industry leaders, particularly Nvidia, a prominent chip manufacturer. Nvidia has outperformed its competitors and now holds the second-highest market value. Consequently, even during periods of stock market growth, certain stocks experience significantly higher gains than others.
This results in a significant level of dispersion, which is a measure of the variation in movement among individual stocks. The level of stock dispersion within the S&P over the next 30 days is currently at its highest point since data collection began in 2014, as indicated by Cboe’s dispersion index in comparison to the VIX. The volatility of stocks in the past was primarily driven by the overall movement of the market.
This is especially evident in the significant reactions to corporate results, even without considering the absurdity of the meme-stock surges (such as GameStop and similar companies that are not part of the S&P).
There were some significant changes in the market recently. Salesforce, a software group, experienced a sharp decline of 20%, while HP saw a remarkable increase of 17% on the same day last month. Additionally, Hewlett Packard Enterprise, a spinout from HP, had a notable jump of 11% last week. During earnings season, news is typically expected, although these developments often occur alongside broader day-to-day fluctuations in the markets. Not this year.
“The risk balance in U.S. equities has undergone a significant shift,” remarks Tim Edwards, the head of index investment strategy at S&P Dow Jones Indices. “The focus has shifted away from market risk and there is now a greater emphasis on idiosyncratic risk.”
This seems like a promising environment for skilled stock pickers. Year after year, active fund managers consistently make this claim, only to be proven wrong time and time again. However, when there are significant fluctuations in individual stocks while the overall index remains stable, it is indeed the case that those who make accurate predictions stand to gain greater rewards.
On the other hand, it highlights the primary drawback of stock picking: A significant portion of those who attempt it will not succeed and, in this particular market, will perform even worse than usual. Investors who analyze stocks from an economic perspective often steer clear of the largest stocks, resulting in negative impacts on their performance this year.
There is concern among some that index volatility could be dampened due to a combination of unwarranted optimism and the use of structured products. In early 2018, a combination of factors led to a significant event known as “Volmageddon.” This event caused a sudden surge in the VIX, resulting in the collapse of the most extreme structures and a significant decline in the market.
I don’t anticipate a similar occurrence in the near future, given the significantly lower VIX levels at that time, the increased correlation among individual stocks, and the rarity of 1% market movements. This year, there was a period of 15 trading days without a 1% move in the S&P, which was the longest stretch so far. The calmness was interrupted by Volmageddon, which put an end to a 93-day period of tranquility.
One potential concern I have is that investors may become overly complacent due to the absence of immediate threats. Any unexpected developments, whether related to the economy, the AI theme, the Fed, or geopolitics, will have a significant impact.
Certainly, feel free to trade those individual stocks, but it’s important not to overlook the significant risks that exist.
