Here's What Really Causes Market Volatility

By definition, "volatility" is the tendency of something to change quickly and unpredictably -- but when the trend of stock prices is moving chaotically and generally upward, it doesn't much disturb our sleep. No, the only kind of volatility that investors get excited about is the downward variety, and that type tends to make us a bit panicky.

In this episode of Motley Fool Answers, host Alison Southwick has invited former Fool Morgan Housel, now of venture capital firm Collaborative Fund, to the studio to talk about Mr. Market's wild ride.

In this segment, he digs into the most common causes of these precipitous slides -- which have very little to do with economics. They also chat about what's really going on behind the scenes when stocks move -- because the actual mechanics of the market have transformed radically from what most of us would recognize.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on May 21, 2019.

Alison Southwick: Let's talk specifically about the recent market volatility. I did a little bit of homework. I think it's because of trade war. Retail sales. What's causing the recent market volatility?

Morgan Housel: I think whenever there's an attempt to say the market fell because of X, it's a dangerous path you're going down. Sometimes it can be fairly obvious. The best example is in 2008 during the financial crisis, Congress voted down the bank bailout and within seconds the Dow went from up 500 points to down 900 points. [With] that you can say that the market fell because of X.

Most of the time I think it's very difficult to pinpoint why the market's falling. If we want to say that the market had volatility in the last week because of the trade wars and developments between China and the United States, I think that makes a lot of sense. And two things come from that. One is that when the market has done very well, as it has over the last 10 years, and valuations are high, things are just much more sensitive to even a little bit of bad news. So even if there's a tiny news story that investors didn't expect, even the tiniest sliver of bad news can send the market tumbling.

That's not the case. If you go back to March of 2009 when valuations were low, even though bad news was coming in day after day -- unemployment was high, people were being laid off, and there was bad news everywhere -- the market was surging day after day. How markets react to news is just in context of the current valuations, and valuations are really high right now.

The other point is that most recessions -- most big economic events -- are not economic events. They're not financial events. They're political events. And I think that's hard for investors who say they like investing but they're not into politics. I think that's a fine mindset, but most recessions are political events and so the causes of recessions tend to be political events. Whether it's from the federal government or the Fed, that tends to be the trigger of most recessions.

When you look at something like a trade war, the economy is doing really well, right now, and has a lot of things going for it. If you look at it through the context that most recessions are caused by political events -- and that's not a partisan statement -- I think that goes on both sides. Just thinking what is going to cause the next recession. Could it be something like a trade war? It certainly doesn't help. So you put those two things together -- the high valuations and then the historic triggers of recessions and downfalls -- and if I had to make an explanation for why the market has been choppy lately, it would be that.

Southwick: I don't want to get too much into exactly how the sausage is made, but I think some of our listeners have an interest in knowing how the market works. What is actually happening here, when someone buys a stock or sells a stock? So in these moments of volatility, how I picture it is a bunch of bros on Wall Street yelling, "Sell, sell, sell." But that's just me watching Wall Street movies.

Housel: And that was 100% true as recently as 10 years ago. It's completely untrue whatsoever anymore. If you look at pictures of the New York Stock Exchange, today, where it used to be the bros yelling, "Sell, sell, sell," it used to have literally a thousand people on the floor. If you go back to the '80s, which was probably the peak of the human trading era, there was probably a thousand people on the floor of the New York Stock Exchange.

You go there today, and it's 20 people, 19 of whom are CNBC anchors. It's all been digitized, now. And so much of it still occurs at the New York Stock Exchange -- and then buildings in New Jersey and New York -- but it's all digitized. That doesn't necessarily change the function of markets. Things happen faster than they used to. But I think markets are still fairly efficient right now.

You can point to the Flash Crash of 2010 where the computers went crazy and the market fell 10% or so. But you also had in 1987, which was still heavily dominated by human traders, [when] the market fell 27% in one day, and that was during an era where it was still human traders. So I think markets are fairly efficient, right now, even if it's just a bunch of computers yelling at each other.

There's a bunch of crazy stories about the functioning of markets and how they've evolved over the last year to where it's all computerized trading. And my favorite example is there's two office buildings in New Jersey that account for the majority of stock trading in the United States. It's where a lot of hedge funds and high-frequency trading offices house their servers, and so that's where the trading takes place. There are these nondescript buildings, unmarked because they're high security. If you're a terrorist looking to take out the American economy, that's the building you want.

But within these servers, high-frequency trading became so competitive that there was a fight between high frequency traders to locate their servers closest to the end of the building that was near the cables that exited the building, because they were dealing with such small periods of time -- they call them picoseconds, which are one trillionth of a second -- that they were fighting over, that the amount of time it took for the light to travel through the cable to their server; they would have an advantage if their server was a little bit closer to where the cables came out of the building. So they were fighting for space within the building and where to locate the buildings. That's how competitive it became.

And then there were companies that wanted the shortest cable connecting their computer, because if they had a long cable it would take an extra picosecond for the light to travel through the long cable to reach their server, so they wanted the shortest cables possible. I think that sums up the extent to which it's become competitive down to this level of time; literally this astronomical period of time that's hard to wrap your head around.

But I think for day-to-day investors -- for most people listening to this -- it doesn't have a big impact. But the structure of the market, in terms of how trades are actually executed, has changed so much in the last 10 years. That's true at the institutional level -- for hedge funds, mutual funds, and whatnot.

For most people listening to this, if you are an individual investor and you want to buy 10 shares of Amazon, and you log into your E*Trade account, there's probably another investor in E*Trade who wants to sell 10 shares of Amazon, and so that trade is "internalized" at E*Trade. It doesn't go to the New York Stock Exchange. E*Trade takes care of it right there. They have enough customers that they can just swap it right then and there.

So for most of your trades, for people listening to this, that's how your trade takes place. It never even leaves your brokerage account. You're trading with another E*Trade customer or another TD Ameritrade or Schwab customer. But if you want to buy a million shares of Amazon, that's where you have the computers screaming at each other and fighting over picoseconds.

Southwick: Which is insane! As an individual investor, I can't fight over picoseconds.

Housel: No.

Southwick: So what is your best advice? I have a feeling I know what your best advice is for individual investors, but let's hear it!

Housel: Well, the way to contextualize this is back in 2010 when there was the Flash Crash, if you weren't investing back then it was a period where out of the middle of nowhere, the market fell like 10% and then recovered instantly. It was just this flash crash. And we did a bunch of investigation at The Motley Fool at the time: this big research report on what happened, how it happened, and how it impacted investors.

And we set out at the time to find an individual investor who was harmed by the Flash Crash. And we couldn't find one. We could not find a single person who was actually a victim of this day. The market fell 10% and then rebounded immediately. Who was harmed by that? The answer was hardly anyone. If you had a standing stop-loss order, you may have been harmed by it, but other than that, this was just something that if you were a long-term investor -- or even if you were a short-term investor and you didn't happen to be logged into your brokerage account during this five-minute period when this happened -- it didn't matter. It wasn't that big of a deal.

And I think that's true when you think about high-frequency trading and the function of markets. Even to the extent that the function of markets has increased volatility relative to where it used to be, I don't think the evidence is that great for it. But for most investors the answer is it doesn't matter. It doesn't make much difference to you whatsoever. And even if what's going on behind the scenes are computers fighting over picoseconds, for you, the investor who's going to hold Amazon shares for the next 10 years, it doesn't make any difference whatsoever.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Alison Southwick has no position in any of the stocks mentioned. Morgan Housel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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