Fear, Liquidity and Ambiguity

Robert J. Samuelson, the columnist, suggests that fear is the cause of the stock market volatility.

“The stock market is nothing if not a psychological barometer. The present signal is unmistakable: fear. It's not just that the market dropped by more than half; that decline parallels some previous post-World War II bear markets (48 percent in 1973-74 and 49 percent in 2000-2002). More revealing are the day-to-day movements. From mid-September to Nov. 21, there were 50 trading days; on 25, the market moved 4 percent or more (16 down, nine up), reports Wilshire Associates. In the previous 25 years, there were just 25 daily moves of 4 percent or more. We've gone from one a year to one every other day.”

Fear can make everyone a seller but it does nothing to help buying. The markets are more complex. Even with strong volumes what may be missing is liquidity. The Option Industry Council reports that option trading while up 28% over last year is actually down 21% for November 208 versus November 2007. The NYSE volume for November was down to the lowest levels since December 2004. Volume is off from the high levels of 2007.

Lower trading could be associated with the uncertainty in the market. The result is less liquidity at any price so that there will be more distorted moves, higher volatility and strong down moves matched by quick reversals. The lower volume and liquidity means that there will be greater short-term price pressure effects. Large sell-off seen sell orders come into the market only to be reversed quickly later in the day or the next day. If there is less leveraging by dealers there will be a reduction in market-making. Dealers cannot house positions when there is a price pressure effect move. The greater volatility has a feedback effect. High volatility by itself causes more uncertainty and will reduce volume. If you cannot be certain on the price at execution, there will be less trading.

Ambiguity about policy and stock valuation will also reduce volume and cause a lowering of liquidity. Investors are not substituting one stock for another but moving to cash which withdraws liquidity.

Fear is not a precise term. A story of liquidity and uncertainty can better describe the poor market conditions currently being faced.