An increase in U.S. stock market volatility in recent weeks could mean falling stock prices ahead, if history is any guide.
Stock price volatility, unusually quiet for many years, picked up late last year and continues to rise.
With a rise in volatility comes an expectation from investors that stocks are riskier, meaning investors may have to move money out of stocks or raise their expectations for returns, according to investment theory.
Because price volatility has not followed its usual pattern of rising as the general market falls, some experts say rising volatility could be a sign of a looming correction.
Possible beneficiaries of increased volatility are active stock managers and tactical asset allocation managers, who get better opportunities to add value when stock prices are jumpier.
But investment managers and researchers are not predicting the increased volatility will continue. They say even with the recent increase, volatility levels are closer to where they have been historically.
Volatility tends to fall as the stock market rises; conversely, it tends to rise as the market falls, said David Hall, vice president for the Chicago Board Options Exchange. Volatility generally is a good indicator of market sentiment, he said.
While volatility has risen, stocks also are up more than 4% for the year as measured by broad indexes.
"That's what the big puzzle this year is," said Harin de Silva, director of research for Analytic TSA Global Asset Management, Irvine, Calif.
A relationship of rising stock market volatility and falling stock market prices is "generally quite accurate," Mr. de Silva said.
He said he and his firm are not market forecasters, but he would expect the market to fall if volatility continues to rise.
Likewise, Aamir Sheikh, manager, derivatives research for BARRA Inc., Berkeley, Calif., said an increase in volatility generally means stocks will fall.
Max Darnell, director with First Quadrant, Pasadena, Calif., said more volatile markets generally create more opportunity for active managers to find stocks that add value over passive management.
A more volatile environment is "more conducive" to active management, Mr. Sheikh agreed.
Similarly, any benefits of tactical asset allocation will become more apparent if markets are more volatile and more divergent. And investors will tend to move out of stocks as volatility picks up, assuming their expected return for stocks does not change.
At this point, the increases in volatility are a short-term phenomenon, and are coming after an extended time of very calm markets.
Hence, alarm bells are not going off among institutional investors yet.
Price volatility had been trending lower from shortly after the October 1987 market meltdown to October 1995, said William O. Melvin Jr., executive vice president for Acorn Derivatives Management Corp., White Plains, N.Y.
Last year in particular, price volatility "trended down dramatically," Mr. Melvin said.
That trend reversed in October, when the market posted its first down month in more than a year, he said.
Since then, price volatility, a measure of percentage price changes in stock prices that can be defined in different ways, has been slowly rising.
"More recently, volatilities have increased," but not to historically normal levels, Mr. Sheikh of BARRA said.
In addition, BARRA's "volatility forecasts for the short term have gone up," he said.
A CBOE index of implied volatility - taken from options trading on the Standard & Poor's 100 index - shows a big rise expected in market volatility.
As of the last week of February, implied volatility was hovering in the 17% to 18% range, while the average for the index from January 1995 through Feb. 28, 1996, was about 13%.
Depending on how it is calculated, the long term historical mean volatility of stocks is in the 16% to 17% range.
Mr. Sheikh said volatility can be affected by many things, including Federal Reserve actions or major world events.
Mr. de Silva of Analytic TSA said volatility also comes from "a lot of people getting in and out of the market."
He said a lot of market participants are nervous about the market, and put buying has increased. (Buying a put gives the owner the right to sell stocks at a given price. If prices fall, and all else is equal, the value of the put rises).
He noted his firm has received several inquiries from pension fund executives about the cost of insuring market returns with puts, but they haven't followed through because of the cost.
Jeffrey Rubin, market analyst with Birinyi Associates Inc., Greenwich, Conn., said upside liquidity in the market is not very good, meaning there are not a lot of sellers of stock. That contributes to greater price volatility.
Birinyi research shows it takes only a $3 million net investment in Dow Jones industrial average stocks for the index to move up one point. A year ago, it took $11 million, Mr. Rubin said.
So if cash flows in and out of the market have increased, or even stayed constant, the degree of price changes are also going to be greater.
But investment managers and researchers say they're not certain increased price volatility will continue. Plus, they note volatility levels are just starting to approach normal levels.
Prices still aren't moving as much on a percentage basis as they have on average in the last 10 years, Mr. Melvin of Acorn said.
Mr. Darnell of First Quadrant said the price swings seen in recent weeks are not unusual.
"If you go back to '93, '94 and '95, you see volatility falling in each of those years, with '95 being the greatest," he said. While not predicting volatility will continue at current levels, if it does it's more of a return to normalcy than a sign of unusually great price changes, Mr. Darnell said.
For example, a price rise of 3% can be expected at times from the stock market, Mr. Darnell said. At recent levels, a 3% rise would translate to a rise in the DJIA of about 160 points.
He said much of what is driving stock market volatility is changes in interest rates.
