Why Stock-Market Volatility is Perfectly Natural

With the Dow down another 300 points this morning (yawn), we're all getting used to stock-market volatility. Traders are all psychologists now:

"Psychology and emotion are a big part of what moves the market," said Andrew Brooks, head of stock trading at T. Rowe Price. "We are clearly in a highly emotional and schizophrenic point."

The weird thing is that this feels perfectly natural to me, coming as I do from the world of fixed income.

Bonds are easy things to value: plug a cashflow, a default probability, a recovery rate, and a risk-free rate into your Bloomberg, and it'll happily spit out an unambiguous price which all bond traders can agree on. They might disagree on the inputs, but given the inputs, they won't disagree on the outputs.

Equities, by contrast, are another world entirely. How do you even begin to value such a thing? Companies' cashflows aren't fixed, in the way bond cashflows are: by contrast, they're highly uncertain. But investors can't even agree on the cashflows they're looking at: Ebitda? Earnings? Dividends? Theoretically, using any of these indicators should land someone in exactly the same place as using any of the others. In practice, that's not the case -- especially not if you start thinking about companies like Berkshire Hathaway which don't pay any dividends at all.

And then of course there are all those other ways of valuing companies, too. Book value and Tobin's Q, all manner of internal ratios, proprietary metrics which hedge funds never reveal. During the dot-com bubble, an entire industry sprang up devoted to reverse-engineering valuation models which could conceivably spit out the numbers seen in the stock market. It was a successful industry, too.

In most of these models, a small tweak of a growth rate here or there is likely to have an enormous effect on a stock price, and no one can possibly predict future growth rates with nearly enough accuracy to get a remotely useful bead on where any given stock should be trading. Ultimately, there's only one reliable way of valuing a stock, and that's to look at where it's trading in the secondary market.

But given how uncertain a stock's fundamental value is, there's no reason why its secondary-market value should be precise to within a tiny margin like 1% either way. A move of 3% or 5% or even 9% in either direction is perfectly reasonable, especially when the macroeconomic outlook is hazier than ever. (You try finding anybody willing to forecast US GDP growth over the coming year with any confidence.)

So what's happening now is that stocks are fluctuating in a very big grey zone -- what you'd expect, given overall levels of doubt and uncertainty about the future. And now more than ever, the daily direction that stocks move doesn't mean anything. They're down today but they might have been up: whatever. It's their nature to be fuzzy. You don't need to be "highly emotional and schizophrenic" to get here, you just need to be clear-eyed about all the things you don't know.