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High Volatility



There are many causes of volatility in stocks. First, risk (volatility) can be separated into systematic risk and unsystematic risk.

Systematic or market risk is macro or exogenous in orientation and affects all securities, but not necessarily equally. A few examples of these kinds of factors are interest rates, commodity and especially oil prices, and the geo-political environment. As these elements become more volatile, so do various financial instruments to varying degrees.

Unsystematic risks are specific to a company and include things like revenue and earnings variability, product development, and management. One risk inherent in both is leverage.

Leverage in my mind is the most important factor in assessing volatility (and therefore option prices). It is both specific to companies, seen as balance sheet debt to equity, and macro-economic, seen as amalgamated public and private debt. Companies that have high debt-to-equity ratios have higher operating leverage: As revenues pick up, earnings can increase faster, as they decline, the company can experience cash flow problems more readily. As the economy becomes more leveraged, interest rates and currencies become more volatile, and this affects a company's financial management.

In Todd Harrison's piece, Buying Time, this morning, he points out the high level of debt in our economy. Household debt and corporate debt have doubled over the last ten years as a percent of GDP. The bulls argue that debt does not matter, that only debt service matters ,and since rates are low it is not a problem. The bears argue that debt does matter, that it must be repaid eventually, and if rates rise it will destroy cash flow.

The Federal Reserve is on record stating that it will provide whatever liquidity is necessary and keep rates low enough to grow the economy through this problem. The problem has been so far that every increase in money supply has been met with a decrease in the velocity of money (because of the drag high debt puts on new spending and even corporate investment). So who is right? We do not know yet. We all have our guesses. But one thing is not a guess: Volatility should remain higher than normal because of higher than normal debt.

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No positions in stocks mentioned.

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