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Where is all this stock market volatility coming from?

Sigma Investment Counselors

January 15, 2015

The equity markets have been quite volatile of late with 300 and 400 point swings in the Dow Jones Industrial Average, intra-day, not uncommon.  What is going on?

Many opinions abound, but I would suggest that two major forces are at play. Both of them impact the amount of the “liquidity” for stock trading available.  For a quick primer on liquidity, take as an example an attempt to sell a used car. The seller is much more likely to get a higher price for that car if he or she had more prospective buyers bidding on it and few other similar vehicles for sale.  In a like vein, a buyer is much more likely to get a lower price if there are more used cars available for sale and few other buyers.  With plentiful buyers and sellers, the price of any particular car is more likely to represent its true value.  This is true for equities too.  In the trade, this is called price discovery.

The two major players involved in providing market liquidity have traditionally been the banks and, within the past few years, enterprises called high-frequency traders.  Following passage of the Dodd-Frank bill in 2010, banks were limited in their liquidity providing business called proprietary trading, or trading in financial securities.  Also, as a result of recent concerns over stock market manipulation, high-frequency traders have been under the watchful eye of regulators and therefore have apparently scaled-back their activities.

For long-term investors, the increased volatility is of no concern (although it can be unsettling). In fact, when we are attempting to sell positions, we feel that our clients are advantaged by the price spikes and similarly, when we have to deploy capital, the lower prices prove attractive.

All questions or observations are welcomed.

Bob Bilkie, CFA®

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