You're Not Imagining That Queasy Feeling: Market's Volatility Soars

On gut-wrenching days like we've had lately, one of the few things you can be sure of is that somebody will point out how, in absolute terms, things are not so bad.

Bring up Monday's 349-point decline in the Nasdaq Composite Index, and one of these helpful souls will point out that, in percentage terms, Aug. 31, 1998 was worse. Talk about Tuesday's whiplashing, and you'll be reminded that it's nothing compared with the Oct. 28, 1997 snapback. The message? Things Aren't As Bad As You Think.

If, despite all this comforting, you still feel the market is rocking like never before, there's a reason: It is. Historical, or real, market volatility has been trending higher since the mid-1990s. And it doesn't look like it's going to get any better.

You Can Still See and Walk

One big reason the market's begun to hop around so much is that its makeup is now so different. In 1995, when volatility was at its nadir, tech stocks made up less than 10% of the S&P 500. Now they make up about 33% of that index. (Fun fact: Some consider the S&P underweight in tech, because technology's weight in the overall U.S. stock market is something north of 40%.) Because these quick-growing companies are priced on what investors expect them to earn years from now, they carry very high price-to-earnings multiples. And because of those very high multiples, incremental changes in a company's outlook can mean huge changes in price, hence, more volatility.

The speed with which tech stocks have gone higher has also played a role. Even if the tools and access to information had been available, it's difficult to imagine today's rapid-fire trading in the steady-as-she-goes market of the early 1990s.

"The thing that's going on now is what I call gradient investing," says Byron Wien, chief U.S. investment strategist at Morgan Stanley Dean Witter. Many investors, Wien believes, recognize the current market as a once-in-a-lifetime event (halcyon days, he says) and are determined to make hay while they can. As a result, there's a real desire to get into the hottest stocks, the proverbial "next Microsoft (MSFT Quote)," and to exit anything that's tending toward tepidity.

The S&P 500 Gets Choppy

Source: Merrill Lynch

"The people who are doing this are daytraders," reckons Wien. "There are a lot of them and they have, in the aggregate, a lot of money. They accentuate the short-term trend and make the market seem more volatile."

No matter where it comes from, volatility affects investor behavior across the board. Explains Merrill Lynch equity derivative strategist Silvio Lotufo: "Obviously, as volatility goes up, people are more nervous. If people are more nervous, they're more likely to react and change their investments on a shorter-term basis."

Makes sense. If you're up big, and you know the market hops around a lot, you're more likely to take some off the table. If a stock starts underperforming, you cut your losses. Writ large, this shortens the entire market's investment horizon, in effect taking everybody a step closer to daytrading.

And you know what happens when investors act more and more like daytraders? More volatility, of course.