All is calm on the front. It may be a calm before the storm.
To the large group of currently unemployed people, there is nothing calm about this economy, but the financial markets are at ease. Standard measures of risk or uncertainty in the stock market suggest nothing above average.
Overall risk or uncertainty in the stock market is measured by what is known on Wall Street as the Fear Index. The CBOE Market Volatility (VIX), an index of stock option trading from the Chicago Board Options Exchange, fell 1 percent on Wednesday to 21.54, very close to the long-run average.
The index reflects the cost of hedging risk through the sale or purchase of option contracts on the S&P 500 index of U.S. stocks. This cost rises when prices move dramatically in one direction or another, reflecting greater uncertainty over what their price will be in the future.
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At the peak of the financial crisis, the VIX was over 70 for many weeks, more than triple the current level. As the crisis abated, the index fell dramatically but spiked earlier this spring and summer.
Even with the uncertainty surrounding the November elections, the financial markets are calm today. This doesn’t mean that stocks are without risks. Most stocks have surprisingly low risk, but some are facing higher risks than ever before.
Financial economists measure the risk of individual stocks using something called beta. The second letter in the Greek alphabet is used to denote a stock's risk relative to the risk of the total market.
Beta is statistical measure of the relationship between the return on an investment in the company stock and the stock market as a whole. If a stock’s price moves in tandem with the market, it will have a beta of 1.
A stock price with less-than-average risk will have a beta less than 1. These stocks are often called defensive and include such well-known names as McDonald’s Corp. and The Coca Cola Co.
Aggressive or risky stocks have beta values greater than 1 and move more than the market average. Sandpoint-based retailer Coldwater Creek Inc. has a beta of 2.74. A 1 percent drop in the overall market could cause a nearly 3 percent drop in Coldwater Creek’s stock price.
Just like the decline in the VIX’s market volatility, the beta value for many stocks has dropped. Companies operating in what would normally be considered risky industries now have beta values close to 1.
At 1.09, Boise-based U.S. Ecology Inc. has a beta very near the overall market. The stock of this radioactive waste service company is moving in line with the rest of market. Supervalu, owner of Idaho’s Albertson stores, has a similar beta of 1.07. If on any given day the market rises by, say, 1 percent, these two companies should see their stocks rise by just over 1 percent.
The high beta risk for Coldwater Creek is not true for all retailers. Talbots Inc., which announced this week it plans to close about 75 stores in the next few years, has a beta of only 1.06.
Two factors seem to be at work here. First, the beta for many stocks is moving toward 1 as stock prices become more correlated. Since many more investors are using exchange-traded and other index funds, stocks are moving at the same time and in similar directions.
A second factor is that the volume of trading on the stock exchanges is falling. The number of shares traded each day on the New York Stock Exchange has dropped over the last two months to between 3 and 4 billion shares per day. This compares to between 5 and 6 billion shares trading each day early this year and throughout 2009.
As we get past the November elections, volume will most likely pick up, and the economy may also pick up, but not all companies will benefit the same. Both the VIX index of market risk and individual stock risk as measured by beta are likely to rise.
Be careful out there! A storm of volatile stock prices may be just over the horizon.