Volatility? Shocking!

The news flow this week has put equity markets into one of their periodic panics. It’s been almost a year since the last one, so in the long term, this might be healthy. Healthy or not, it’s peculiar how closely these shakeouts have coincided with the political calendar, and judging by available academic research, the market should be better prepared for air pockets like the current one. For example, according to a 1997 study by Lamb et al:

Almost the entire advance in the [stock] market since 1897 corresponds to the periods when Congress is in recess. This is an impressive result, given that Congress is in recess about half as long as in session. Furthermore, average daily returns when Congress is not meeting are almost thirteen times greater than when Congress is in session. Throughout the year, cumulative returns during recess are eight times that experienced while Congress is in session. [emphasis added]

Or this 2006 study by Michael Ferguson and H. Douglas Witte:

We find a strong link between Congressional activity and stock market returns that persists even after controlling for known daily return anomalies. Stock returns are lower and volatility is higher when Congress is in session. This “Congressional Effect” can be quite large—more than 90% of the capital gains over the life of the DJIA have come on days when Congress is out of session. The Effect varies systematically with the public’s opinion of Congress: returns are lower and volatility higher when a relatively unpopular Congress is active. Public opinion appears to play a fundamental role in market prices. This is consistent with a mood-based explanation that sees Congress as ‘depressing’ the average investor. Alternatively, our results can also be reconciled with rational explanations that view Congressional activity as a proxy for regulatory uncertainty or rent-seeking behavior. [emphasis added]

Federal policies have a powerful effect on asset prices, and risk aversion has been very low until this week. With Congress back in town, the President on the war path, and widespread gnashing of teeth and rending of garments over budget deficits and the federal debt, volatility had nowhere to go but up. Our advice? Don’t worry about it (too much). It would be great if our elected leaders inspired more confidence and certainty, but political noise happens — the current bout might even need to happen in order to get satisfactory regulatory reforms enacted. However, we have one of the best (if not the best) political systems for correcting political errors. 

The big question ahead of us is how closely we’ll skirt a 1937 outcome, which shouldn’t be a material risk until 2011-12. The Treasury yield curve will probably provide the best clues. If longer term yields come down considerably in 2010, watch out. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. 

URLs:

http://www.unf.edu/~rlamb/Docs/FinServRev.pdf

http://www.fma.org/Orlando/Papers/Congress_and_the_Stock_Market.pdf