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Why A Rise In Economic Volatility Could Hurt Your Investments



While no single explanation fully captures why volatility has risen, in my view the rise in equity market volatility can primarily be attributed to a rise in economic volatility. Work done by my colleague Daniel Morillo demonstrates that the volatility of financial assets is closely correlated with the volatility of the underlying economy. In less stable economic environments in which recessions are more frequent and economic measures more volatile, financial assets tend to be more volatile as well.

Rise in economic volatility usually leads to rise in asset-price volatility

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Market Realist – A rise in economic volatility is correlated to financial assets’ volatility.

Above is the historical price chart for the S&P 500 (SPY)(IVV). The index saw a bull run spanning two decades before the tech (QQQ) bubble. At the time, the index hit an all-time high of around 1,520. The period between the mid-1980s and the tech bubble saw the US GDP (gross domestic product) gallop. There was less volatility. In this period, the S&P 500 also soared with relatively low volatility.

However, after the tech bubble burst, the GDP saw higher volatility between 2001 and 2003. The GDP growth slowed down. This is when the markets were very volatile (VXX). Growth picked up again after 2003. The index picked up as well. It was mostly one-way traffic. There was reduced volatility for both.

However, the financial crisis arrived in 2008. Growth came to a grinding halt. Markets became very volatile again because investors were spooked. The US, along with the rest of the developed world (EFA), slipped into the Great Recession.

This shows that the volatility of the US GDP and the S&P 500 are highly related. Since the world is slowing down, the US should as well. It’s fortunes are intertwined with the world’s fortunes.


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