Fall in stock volatility may not last long
Investors don't need a newspaper columnist to tell them that the last year has seen some terrifying stock market volatility.
After three years of exceptionally calm trading with only small day-to-day price movements, the Hong Kong stock market went crazy around about the end of July last year.
Suddenly prices began swinging wildly, with annualised 10-day volatility shooting higher, from a level typically between 10 and 20 per cent, to reach fully 100 per cent in mid-January 2008. It has since subsided, but at a shade over 20 per cent, stock market volatility remains well above the levels that prevailed for most of the last four years.
Of course, volatility cuts both ways. Ordinary investors, who tend to buy stocks and hold them (if only briefly) like periods of volatility during which the market climbs, and loathe and fear volatile times in which the market falls.
Unfortunately, however, volatility is unequally distributed. Experience tells us that markets tend to plod higher, then plunge lower, which means unusual price swings usually hurt rather than help the ordinary share buyer.
Clearly the level of market volatility is important. But working out what drives volatility is hard, and attempting to forecast it is fiendishly tricky.
Despite the difficulty, Gary Evans and his team of equity strategists at HSBC have had a go.
First, they looked in the obvious places. No, volatility has no obvious relationship with market turnover. Illiquidity, it seems, does not necessarily exaggerate price movements, as many believe. Nor is there any clear correlation between the volatility of underlying fundamental factors like economic growth and stock market volatility.
Then they discovered something interesting. Volatility is correlated with interest rates. When rates rise, so does the violence of stock market price swings, although often with a time lag.
For the Hang Seng Index, the relationship holds even with no time lag. For H shares, the correlation with mainland rates works best with a six month lag.
This correlation should not be too surprising. Higher interest rates equate to greater uncertainty for economies, companies and investors, and uncertainty means volatility. Moreover, in times of high interest rates, ordinary buy and hold investors, who tend to look for absolute rather than relative returns, will often opt to keep their money in the bank, destabilising stock markets.
By now this is probably sounding alarm bells. Hong Kong interbank rates have risen by around half a percentage point in the last few weeks, and futures markets are pricing in a similar rise in US rates before the end of the year. If they are right, we could soon see another rise in stock market volatility.
This is all very interesting, but of course what really drives volatility is not interest rates but the eternal tug of war between greed and fear.
Volatility rises when either reaches extremes. Levels of volatility rise in a stock market bubble as greed triumphs over common sense and investors rush to buy before they miss the opportunity, driving prices sharply upward. Then when the market rolls over, volatility shoots even higher as frightened shareholders all attempt to dump stock simultaneously and prices collapse.
Now perhaps if Mr Evans and his crew can come up with a way to measure greed and fear - a way which does not rely on stock market volatility - we will really be getting somewhere.