Market Volatility Is the Highest Since Hoover-FDR Transition
Robert Engle, awarded the Nobel Prize for Economics in 2003 for his study of market volatility, currently teaches at the Stern School of Business at New York University. He spoke to NPQ in November.
NPQ | What are the causes, rational and irrational, of the extreme stock-market volatility we have been witnessing these past few months?
Robert Engle | The main cause of market volatility is new information and uncertainty about what the future is going to look like. What we see today is incredible uncertainty about the future of the banks, and the future of the American economy and the global economy.
That translates into people seizing on every shred of evidence to buy or sell stock, moving prices dramatically even during the course of one day.
Because we are in a totally new and unfamiliar environment, one cannot honestly distinguish between a “rational” or an “irrational” decision. People are using all kinds of different models and have different portfolio needs, such as redemption calls on mutual funds, to assess new information. So, from the standpoint of one model, buying or selling makes sense but from another angle it doesn’t. There is a great deal of uncertainty.
NPQ | Why so much uncertainty? How did we get from the sub-prime mortgage crisis to Citibank’s market capitalization evaporating in a few days’ time?
Engle | We understood that the housing market was in the tank and that affected a variety of industries. We also understood that the banking sector had taken on immoderate risk in housing, but we didn’t have enough disclosure to properly assess the real damage.
Added to that, in the fall of this year, we became aware that the rest of the economy, in fact the global economy, was falling apart as well. The United States economy had been bolstered by the strength of the export market. The manufacturing and technology sectors were doing quite OK.
But the export sector, we came to see, would slow down if the rest of the world did. While energy stock prices were high when exports were, as soon as we saw a global slowdown coming oil prices also collapsed.
Last summer, the correlation between equity returns across industries was quite low. Now they are all similar. We are all going down together now. There is a cascade of new information—and it is all bad.
NPQ | What new information is ever going to settle the markets? Across the Western world, banks have received huge injections of capital. All kinds of bailout plans are on the drawing board. The g-20 met and promised they would watch over financial markets in the future. The list goes on.
Engle | At this moment, nobody can think of a piece of news good enough to indicate we are coming out of this. We can’t imagine what that might be. Possibly it’s news that other economies are not doing as poorly as that of the US, that, perhaps, China’s big stimulus is helping, and they are not slowing down as fast as we fear.
The only thing that will turn markets around is when the economy itself is gradually turned around. Saving the banking sector is not sufficient to make the economy grow again. And without income growth the housing market won’t recover. And without a housing recovery, the rest of the economy won’t move. As far as I can see, only a large, Keynesian fiscal stimulus will do the trick.
NPQ | So, “fear itself”—distorted information and the resulting panic—is not the problem. It is the real collapse of the economy driving the market down?
Engle | The signals are correct. It is the real weakness of the economy that is driving market volatility. I hope I’m wrong, but that is what I see.
All this selling is by people who thought in the spring that they had sold enough and we would come out of this without too much pain. Now they feel—oops, no, the economy has really gone south; let’s get out before we lose everything.
NPQ | How does today’s stock market volatility compare to that of the Great Depression era, during the transition period between Herbert Hoover and when FDR took office?
Engle | I’ve done studies comparing today’s volatility index to that of the Great Depression era. The volatility index today is up between 60–80 percent, which is extraordinarily high.
In 1987, market volatility actually spiked to 140 percent, but it was very short-lived and had no macroeconomic impact.
But if you compare the volatility index to the Depression era, it spiked in 1929 to 100 percent, then decayed rapidly to about 20 percent within six months, then rose again to a sustained high level of about 50 percent from 1932–1935. After that, it gradually declined.
Its highest level was at the end of 1932 and beginning of 1933—the period of transition between Hoover and Roosevelt. This indicates that the kind of high volatility we are seeing today is the result not just of economic uncertainty, but also political uncertainty.
What is the government going to do? How effective will those policies be? No one has a confident answer to that yet.