Market Volatility Expected To Continue Next Year

Stock market volatility returned with a vengeance in 2007 and is not going away anytime soon.

The rise in volatility was reflected in the kind of year financial markets had, marked by big market swings due to the worsening global credit environment.

"We believe that the markets have shifted to a higher volatility regime," said Edward Tom, head of equity derivatives strategy at Credit Suisse.

Broker works the trading floor at the New York Stock Exchange.
Broker works the trading floor at the New York Stock Exchange.

Volatility may remain high in 2008, most analysts say, amid expectations that credit losses concentrated in lower-quality subprime mortgages will broaden to affect many borrowers once
thought good credit risks, as well as other types of debt, including credit card and auto loans.

Uncertainty regarding the Federal Reserve's interest rate policy, along with unstable oil prices and a slowdown in the housing sector, could also be drivers of volatility.

"Corporate fundamentals within the current economic environment point to the likelihood that market volatility will trend at a higher baseline level in 2008 than it had prior
years," Tom said.

Deutsche Bank's equity derivatives strategy group, in a Dec. 14 note to clients, predicted volatility is here to stay.

"We believe volatility will remain high in 2008 as the (liquidity) crisis drags on and the macro drivers of volatility, brought on by the recent Fed moves and credit tightening, continue to play out," it said.

Credit Suisse's Tom noted one reason volatility was so low through the last five years was because hedge funds piled into selling strategies that primarily involved Standard & Poor's
500 index puts, originally bought to protect their portfolios.

They also sold market volatility at lower levels through variance swaps, a product that expresses a play on actual volatility, he said.

But during the last two subprime meltdowns of 2007, these hedge funds had to unwind their short positions and as a result, much of the trading pressure responsible for lower volatility has been removed, Tom said.

More volatility is not necessarily a harbinger of lower stock prices, analysts said. For example, stocks were very volatile during the bull market in the late 1990s.

Higher volatility also provides opportunities for strategic traders. Investors can now trade volatility products and "therefore, it is possible to make money on volatility, regardless of stock market direction," wrote Larry McMillan, president of options research firm McMillan Analysis Corp, in his newsletter "The Option Strategist."

Futures and options on the Chicago Board Options Exchange Volatility Index, or VIX, had a banner year as investors sought out those instruments to hedge their portfolios or speculate on adverse and unexpected outcomes, said Andrew Wilkinson, senior market analyst at Interactive Brokers Group.

As the new year draws near, the VIX, Wall Street's main meter of investor fear, is near halfway of the peak reading it hit during the stock selling climax in August.

The indicator, which reflects investors' expectations of near-term volatility conveyed by S&P 500 option prices, is hovering around 20.

The days of calm and investor complacency may be things of the past.

"First signs that equity volatility was coming back revealed themselves as early as spring 2007. The credit crunch followed in the summer, along with a rise in volatility that still hasn't subsided," Deutsche Bank said.

DB strategists also highlighted that in the past, volatility regimes have lasted years, not months.

For example, volatility has historically risen after a steep U.S. yield curve inversion, in which short-term interest rates are higher than those for longer-dated instruments.

The Federal Reserve's benchmark federal funds rate, at 4.25 percent, is now above U.S. Treasury yields out to the 10-year maturity.

Going back to 1982, extreme peaks in yield curve inversion were often followed by higher equity volatility over the following 24 months, according to the bank's research.

"The U.S. yield curve inverted to a historically steep level in the summer of 2007, and -- if history repeats itself -- equity volatility could be materially higher over the next
couple of years," Deutsche Bank said.