Chart of the Day: Shift in Market Dynamics Over the Years and Associated Risks

The stock market uptrend in the 1990s had higher volatility than the downtrend that followed based on the frequency on low volatility days. In the 2000s there was a shift with uptrends having lower frequency of low volatility days and downtrends high frequency. I offer some explanations for the shift. This shift in market dynamics poses high risks.

I have constructed an indicator that measures the percentage of days in a given period with absolute return higher than X%. On the chart below this indicator is plotted for SPY since inception and for a period of 250 days and X% = 0.5%, i.e., this indicator measures the percentage of higher volatility days (absolute return > 0.5%) in a given period.

SPY_20150324

It may be seen that along the uptrend of the 1990s the percentage of days with absolute daily return higher than 0.5% increased steadily from about 30% to nearly 70%. Then, after the market top of 2000 the percentage fell to about 60% and again rose to 80% during the bottoming action.

However, during the 2000s the percentage of absolute returns higher than 0.5% in a 250-day period fell steadily from 80% to nearly 30%, i.e., the action was a mirror image of that observed during the 1990s. That was a major shift in market dynamics. This shift was further confirmed by the percentage rising during the downtrend that followed due to the financial crisis from 30% to about 80%. Then, after the 2009 bottom, this percentage fell again to about 45% only to rise during the 2011 correction back above 60%. Then, after the decision to fully support the market with low rates and QE, the percentage fell again towards 40% as the uptrend continued.

Some plausible explanations

In the 1990s, traders and investors would become more uneasy as prices rose because there was not any fundamental support provided as a guarantee of higher prices, as it is the case nowadays. Then, during downtrends, there was no panic because the downtrend was viewed as a natural development.  In the early 2000s and as the number of technical traders and active managers were being arbitraged out by market makers and algos, daily volatility fell. This is also the time that many gave up trading to turn to passive investing and active investing was getting bad publicity, often unjustifiable. The rapid reduction in the number of participating human traders caused volatility to drop but when the financial crisis erupted, volatility went out of control. This is when the exchanges decided to provide more benefits to HFT, including front-running, in exchange for the provision of market liquidity, something that was done by human traders and fund managers in the past. The hope is that the next downtrend will not have high volatility but due to the new micro-structure, a correction is delayed and it may happen suddenly, as every algo will do the same thing at the same time. We got a taste of that during the flash crash.

Part of the shift in market dynamics was the result of greed by human market makers in exterminating human traders. In turn they were replaced by algos. The problem is that human traders will not be coming back to the stock market in large numbers unless HFT is taken out of the loop. A transition back to human liquidity is almost impossible due to the risk it poses. Thus, in my opinion, the risks of a sudden large correction in this market are high unless there are more measures put in place and more guarantees issued. By sudden collapse I mean to a drop of more than 30% to maybe 50% in a matter of a month or two. The risks are evident from the above chart.

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Disclosure: no relevant positions.
Charting program: Amibroker
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