Volatility in stocks makes a big comeback — with the Fed’s help | Peter Crabb

Volatility is back. We shouldn’t be surprised, as this defines risky investments like stocks. But perhaps this is more than we should expect.

Economists track financial market risk, or uncertainty, using prices on stock option contracts. The most famous measure of these prices is the Chicago Board Options Exchange’s Market Volatility index, or VIX. This so-called “fear index” is based on stock option prices for the large, U.S.-based companies in the Standard and Poor’s 500 Index.

The VIX index reflects the cost of protecting investment risk through the sale or purchase of option contracts — often called hedging.

Option prices rise when the underlying stock prices move dramatically in one direction or another, as they have the last few weeks. The higher prices of these financial contracts reflect greater uncertainty over future stock prices.

At the start of this year the VIX index was around 14%, quite low compared with its long-term average of around 20%. A VIX value of 20 means that we should expect to see stock returns deviate from their long-run average return of 10% by 20% on an annualized basis.

In terms of probability, a 20% standard deviation means there is approximately a 1-in-3 chance investors will lose money over the course of any given year. Earlier this week the CBOE VIX traded over 70%, a level not seen since the financial crisis of 2008. By this measure, there is nearly a 50% chance of loss in the stock market over the next year.

Such a downturn is hard to imagine given that stock prices are already more than 20% over the highs reached in February. The economic uncertainty of this global pandemic is clearly evident.

Also high is the level of government intervention and debt. The Fed has never withdrawn its “emergency” interventions of 2008 and 2009.

The Fed owns nearly $4.4 trillion in government, and government-backed debt instruments. This is four times what it owned a decade ago. The Fed announced this month a $1.5 trillion commitment to banks for short-term funding and the purchase of an additional $700 billion in government or government-backed debt.

Economist Ludwig von Mises warned decades ago that such interventions are inherently unstable. The first intervention mitigates the issue, but leads to further interventions that never solve the problem. With all the increased financial leverage the Fed has provided the market, we should continue to expect price volatility.

Volatility is not just back. It’s here to stay as long as the Fed keeps intervening.

Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. prcrabb@nnu.edu

This story was originally published March 17, 2020 at 5:00 AM.