How Has The Stock Market Changed?
A common description of the stock market these days is that it is experiencing some of its highest volatility in history. A host of explanations are being offered, and include the advent of exchange-traded funds (ETFs) that are designed to return 300% of the daily stock market's performance, whether up or down. An emphasis on shorter-term trading strategies are also blamed, be it momentum investing or day trading philosophies. Below is a brief overview of how the stock market has evolved in recent years, and some conclusions on whether it has truly become more volatile.
TUTORIAL: Market Crashes
Looking out over the past decade, it certainly appears that the market environment has grown more volatile. Last year, financial media firm CNBC provided details of the biggest stock market drops in the history of the United States. Of the top 10 largest point drops in the Dow Jones Industrial Average, eight have occurred in the 2000s, with six occurring in late 2008 alone as the credit crisis hit its most dramatic point. The remaining two happened in 1997 and 1998. The percentage drops have also been extreme and range roughly between 5 and 8%. The Nasdaq market, with an emphasis on technology-related company listings, posted nine of its 10 largest point declines in 2000 as the dot-com bubble was bursting. The other largest drop occurred, again, during the latter stages of the credit crisis in late 2008.
Technology, and the subsequent shift to program trading by computers, has been a major market shift. This has allowed trading volume to skyrocket. The Stock Market Crash of 1987, which saw the Dow plummet 507.99 points, or 22.61% on Oct. 19, 1987, was blamed on program trading that caused investors to rush for the exits in an extreme example of herd behavior. Currently, there has been speculation that flash traders, or investment shops that employ high frequency trading to buy and sell huge amounts of stocks, are creating unusually heavy market volatility. (For additional reading related to investors acting in the market, read Understanding Investor Behavior.)
In the 1990s and 1980s, it was much more common for markets to fluctuate less, or closer to 1%. Technology has allowed a wider array of individuals and market participants, such as flash traders, to influence the markets. Technology has also made it possible for leveraged ETFs to be created. In previous years, institutions, including banks and brokerage firms that offered a full-service approach to individuals, had more of a lock on the market. The advent of the internet, and digital information exchange, has replaced analysts and brokerage houses that could better control the flow of information, such as analyst reports, Securities and Exchange Commission filings, and communicating with company management teams.
A shorter-term investment time horizon could also have contributed to much higher levels of volatility in recent years. An obsession with quarterly performance, and subsequent emphasis on shifting out of investments that don't pay off within a quarter, or even a shorter timeframe, increases turnover. Institutions, in the past, had a reputation for being able to take a longer-term investment time horizon, which may also have stemmed from the slower dissemination of information. (For more on short-term investing, read Do Your Investments Have Short-term Health?)
The Bottom Line
Throughout the stock market history, there have been other extremely volatile investment environments. The stock market crash of 1929 saw extreme market movements, and occurred well before markets traded electronically or high frequency traders existed. The 1970s represented another period of above-average volatility as U.S. markets experienced rising inflation and stagnant economic growth.
The uneven market environment over the past decade could be due, primarily, to the bursting of two historic bubbles in technology stocks and housing, the last of which brought on the credit crisis. Without these factors, it's difficult to say whether technology, and a short-term trading mindset, would have resulted in high levels of market volatility. In any case, there is little question that investing has changed profoundly from previous years.