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Reading the Right Tea Leaves to Gauge Market Volatility

August 23, 2012

Over extended periods of time, market volatility has been linked to uncertainty in broad macroeconomic prospects and not the latest breaking news headline.

-Daniel Morillo, head of investment research, iShares

Investors have become all too familiar with volatility in recent years as dramatic events like the Lehman Brothers bankruptcy and the downgrade of US debt have rattled global markets.  Last month, my colleague Russ Koesterich said in a blog that he expects volatility to remain elevated for the remainder of the decade.

That call might seem quite bold given the difficulty in predicting the type of individual events that tend to trigger volatility in the markets. But Russ wasn't reacting to short-term events when he wrote that post. Instead, he was focused on underlying trends that could influence longer-term behavior of the markets.  Why? Well, over extended periods of time, market volatility has been linked to uncertainty in broad macroeconomic prospects and not the latest breaking news headline.

There is a large body of academic literature that explores this link. But I'd like to illustrate this relationship using two simple macroeconomic metrics - economic growth and changes in the money supply.

First, let's look at economic growth. Poor economic growth makes investment planning generally more difficult and more sensitive to specific market, political or policy events. As the chart below shows, since the 1960s US consumption growth (or lack thereof) has accounted for about 30% of the variation in annual volatility for the S&P 500 index[1]. In other words, the more consumption growth, the lower volatility and vice versa.

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