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Market Volatility Surges Even as Valuations Soar

As market pros get more nervous about that disconnect, investors shrug and keep on buying.

On days when the market goes up or down more than 100 points, there's usually some helpful person there to talk about how such a move isn't what it used to be. After all, these days a 100-point move on the


is less in percentage terms than a 50-point move would have been four years ago.

If, despite such reassurances, you still feel like the market's been turning more and more into a roller-coaster ride, there's a good reason: It has.

Stock-market volatility, which fell to unnaturally low levels in the middle part of the decade, has been climbing steadily since 1996. This is true of both implied volatility and realized volatility. Implied volatility represents the premium investors are willing to pay for options -- when it moves higher, it reflects nervousness in the markets. Realized volatility is a historic measure of how volatile stocks have actually been. "Historically, both implied and historic volatility are pretty high," said Silvio Lotufo, equity derivative strategist at

Merrill Lynch


Now, normally, if stock prices are getting more turbulent, that gives investors pause. The more volatile the price of something is, the higher the risk of investing in it. One need only need to look at the 2% and 3% moves that bourses in places like Thailand have to get some sense of this. Something that carries more risk should carry a higher risk premium (a fancy way of saying it should cost less). But that certainly doesn't appear to have been the case in the U.S. stock market over the last few years.

"There used to be a rule that when volatility went up, the market went down, and when volatility went down the market went up," said Rich Bernstein, chief quantitative strategist at Merrill Lynch. "However, certainly of late, one would have to argue that investors just don't care."

Stock valuations have moved consistently higher in the last few years. In 1996, the price-to-earnings ratio on the

S&P 500

ranged from 15 to 19. In 1997, it ranged from 17 to 23. And in 1998, it ranged from 20 to 28. Right now, it's around 28.

All things being equal, seeing both volatility and valuations climb doesn't make sense. All things aren't equal, of course. Valuations on the S&P 500 may be higher because investors see the long-term prospects of U.S. companies as better than they were in the past, and for all we know that expectation may be rational. Furthermore, the stocks that make up the S&P 500 have changed over the last few years. There are, for instance, more tech stocks in the index, and these are more volatile and carry higher valuations than run-of-the-mill issues.

"As we go through the '90s," said Doug Cliggott, market strategist at

J.P. Morgan

, "the composition of this thing is changing. In a way, that appears to be raising its fair-value price-to-earnings multiple. Higher-growth, higher-P/E stocks are coming into the index, and because it's successful, it's feeding on itself."

'There used to be a rule that when volatility went up, the market went down, and when volatility went down the market went up,' said Merrill Lynch's Rich Bernstein. But lately, 'one would have to argue that investors just don't care.'

It's also important to remember, Cliggott notes, that U.S. stocks are fighting it out for capital with other markets. While the U.S. stock market got more volatile, so did stocks in other countries. When you look at volatility vs. return, the U.S. still looks pretty good. Meanwhile, the yield on 30-year Treasury has slumped to near 5%. Low yields not only make it possible for stocks to carry higher valuations, they make the Treasury market a pretty unexciting place to invest.

Along the same vein, Tim Hayes, senior equity strategist at

Ned Davis Research

in Nokomis, Fla., points out that as the market shook, it may have been smaller stocks that have paid the price. Rather than flee the market once it started to tremble more, investors have been getting out of small-caps and putting their money into the big-cap issues that dominate the S&P 500.

Hayes is nervous about volatility levels, nonetheless. Spikes in volatility come at breaks in the market -- you can see them, for instance, in November 1997 and October 1998. The top of the spike is a great place to buy -- for that is when the fear in the market is at a fever pitch. When everyone is saying the world will surely end. Which, thus far, hasn't happened.

But when volatility is still climbing, things aren't so good, and Hayes worries about this continuing trend of higher volatility. "If this continues," he said, "you would eventually expect the market to respond the way it normally does. This is not good for the market's long-term prospects."