Market watch: A history of violence
While the reason for this particular bout of choppiness in the financial world is unique, such spells of volatility have been witnessed often in the past, writes Udayan Mukherjee.india Updated: Aug 13, 2007 21:35 IST
The financial world has become a very volatile place in the last three weeks. While the reason for this particular bout of choppiness is unique, such spells of volatility have been witnessed often in the past.
It may be instructive to look back and analyse the historical patterns.
One thing that leaps out is that spells of high volatility do not last long. In February this year when global markets dipped, the CBOE VIX, which measures volatility, rose 60 per cent on average.
That lasted for about five weeks after which sanity returned. The same in May 2006 when the brutal global sell-off saw volatility spike 50 per cent over a five-week period after which it remained stable for 36 weeks.
In October 2005, the VIX rose 27 per cent for about a month and then subsided. In each of these periods, there was a sharp global sell-off but it never lasted very long.
The pain was more in the sharp contraction of prices, never in a protracted period of volatility or decline. This piece of empirical evidence is very important. It indicates that bouts of extreme volatility almost never last for more than four to six weeks.
What follows is either a phase of consolidation, where prices take months to reclaim their lost ground, or a V shaped recovery, every bit as sharp as the fall.
To illustrate with a global example, in 1998 when the LTCM crisis unfolded, the Dow lost 17 per cent in one month and then recovered all its losses by jumping 20 per cent in the next 60 days. While I am not suggesting that this will be the case this time, history is best not ignored.
The current spike in volatility is about three weeks old. Going by historical averages, we should be halfway through, already.
What is difficult to predict is the steepness of volatility spikes in the next few weeks and the resultant erosion in stock prices. If indeed we have some way to go.
What is important to keep in mind, though, is the past, which suggests that such violent storms eventually blow themselves out in relatively short spans of time. What finally lasts is the fundamental trend, not volatility.