The Sound of Silence

Usually, when you are in a noisy room, and the noise subsides, it takes a while to realize that it has gotten quiet. But that sound you are hearing in the stock market lately is the sound of silence. Since December 21, the annualized volatility of the S&P 500 has been 12%, well below typical levels, and only one-third of the volatility since August 1. You won’t hear about this calm from the typical financial press – it doesn’t make for good circulation to say there isn’t anything going on. Indeed, the headline in the web edition of CNN-Money one day last week was “Fears of Europe trigger Market Losses” – at that point the S&P 500 was down only 0.2%.

Most of the time, market volatility is triggered by financial news – either about specific businesses (such as bankruptcies, layoffs, or disappointing earnings), or the economy as a whole (GDP declines, unemployment increases, inflation). However, when there is a huge decline in stock values, a second source of volatility can be volatility itself. A sharp decline causes all market participants to be on edge, and to immediately react, and often overreact, to any news or even rumor of news. That is what happened over the last five months; volatility feeding itself, and such cycles take several months to die down. The important thing for investors to recognize is those volatility spikes eventually subside, and the biggest mistake is to overreact and sell at the bottom of the market.

The relative calm over the past two weeks suggests that the volatility cycle, initially caused by the August downgrade of the U.S. credit rating, and exacerbated by the European debt crisis, is over. That is not to say that there will not be volatile days going forward. Daily stock prices will always be affected by short-term news – and in the coming few weeks, companies will be announcing their quarterly earnings, 2011 economic statistics will be released, and of course, the European financial situation will take many twists and turns. Volatility, like noise in a room, might always return without notice. But for now, we seem to be out of the era when 3% daily swings in the market are commonplace.

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