Volatility isn’t the only measure of risk, but it’s a critical one in strategic investing. One need only look at recent history for real-world confirmation. Indeed, volatility has rarely been so extraordinarily high as it has been in 2008. No wonder, then, that real and perceived levels of risk have taken wing.
Volatility analysis has long been popular in the money game and it’s also been a fertile area of study at the macroeconomic level. And yet there’s been little research into how economic and market volatility interact. Helping fill some of the gap is a new academic paper: “Macroeconomic Volatility and Stock Market Volatility, World-Wide,” by professors Francis X. Diebold (University of Pennsylvania and NBER) and Kamil Yilmaz (Koç University, Istanbul).
A widely held assumption about the relationship between the stock market and the broader economy is that the former anticipates trend changes in the latter. But Diebold and Yilmaz’s research suggests that the relationship may actually work the other way around when it comes to volatility trends.
“Markets aren’t necessarily forward looking in terms of volatility,” says Professor Yilmaz in a recent interview with CS. “What we know is that markets are forward looking in terms of returns. If markets expect that the economy will do better, then the stock market booms because it’s looking forward. However, this doesn’t imply that causality runs from return volatility to fundamental volatility [i.e., that markets are anticipating GDP volatility].”
Real Stock Return Volatility and Real GDP Growth Volatility, 1983-2002
Source: “Macroeconomic Volatility and Stock Market Volatility, World-Wide”
Based on his research with Diebold, macroeconomic volatility appears to be a predictor of expected cash flow volatility in the stock market. In other words, higher economic volatility anticipates higher cash-flow volatility.
“Overall, there are periods when countries have higher fundamental volatility and during those times the stock market can’t be expected to be less volatile,” Yilmaz says.