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A not so eerie silence

The unusual stability of share prices does not mean investors are worryingly complacent
October 17, 2017

If you think the stock market has been unusually quiet recently, you’d be right. In the last six months the average weekly change in the All-Share index (regardless of direction) has been just 1 per cent, which is close to its lowest since 2007; the standard deviation of weekly changes has also been close to a 10-year low. This poses the question: does this unusual stability tell us anything about future returns?

Elementary theory says it should. More stability means the equity risk premium should be lower, which should mean lower future returns.

This theory, however, hasn’t often been right. For years there was no link between market volatility (measured by the average weekly move in the All-Share index over six months) and subsequent six-monthly returns. My chart shows that the correlation between the two was around zero from the early 1990s to mid-2000s.

One reason for this is that observed stability or volatility isn’t necessarily a guide to risk.

This isn’t only because past volatility is only a weak indicator of future volatility. It’s also because stability is not a sign that the market is being complacent. To believe this is to commit the 'Mr Market fallacy' – of attributing emotions to what is in fact the unintended emergent outcome of countless individual actions.

Stability is instead a sign of disagreement. If every seller can quickly find a buyer and vice versa prices won’t move much. If, however, everybody agrees that they want to sell (or buy) then we will get big price moves. Agreement generates volatility, disagreement stability. And in recent months, investors have disagreed. This is because while there are reasons for optimism, such as ongoing growth in the eurozone economy, there are also reasons to be wary, such as lacklustre growth, high equity valuations and political uncertainty in the US, and the risk of another slowdown in China.

Which poses the question: why should the degree of agreement or disagreement predict returns? I can’t think of a compelling reason.

And yet since 2010 there has generally been a positive correlation – if not always strong – between past volatility and future returns. Why?

It might be just luck. Stability in late 2010 just happened to precede the euro crisis and stability again in 2014-15 preceded a slowdown in emerging markets and slump in mining stocks. This might be just a statistical artefact.

You might object that there is a mechanism here. Market instability has caused central banks to keep interest rates ultra low and maintain the stock of quantitative easing which has supported share prices, while stability has led them to consider tightening to the detriment of equities.

There’s something in this, but maybe not much. Central banks will only raise rates slowly and only if the economy is healthy enough to take rate rises. Net, this shouldn’t scare stock markets – and indeed there has in the past been a tendency for shares to rise as interest rates rise.

On balance, then, I don’t think we should be troubled by the recent unusual stability of prices. Of course, nasty shocks are always possible – and stability has a habit of giving way to volatility. But the fact the market has been stable is in itself not a strong reason to believe these dangers are especially greater than normal. Not all silences are eerie ones.