Could hyper-volatility kill the stock market?

Describing it as a roller-coaster week on the markets doesn't really sum it up. Neither does whiplash. In fact, after the extreme volatility of the past week we probably need some new metaphors. An earthquake, perhaps, or a supernova. Indices drop by 5% on one day, then rise by 4% the next, before falling by 6% the following morning, and jumping by 5% after lunch. The mood changes at lightening speed.

Wise old hands are tempted to say that it is just markets being markets. The only sane way of coping is to stop checking your portfolio too regularly. Take another look at it after Christmas and it will probably still be in reasonable shape. There is some truth in that.

In fact, as many people have noted, the FTSE-100 index closed when it was slightly up last week. Nothing much happened, except it went down a bit, then up again. A few trading desks at the big banks may have lost some money. A few of the smart new breed of hedge funds set up to profit from volatility might have done well. For the people marketing the Black Swan and Armageddon funds, it was certainly a good week. But apart from that, it didn't make much difference. No real harm was done. It is a comforting view. However, it's also dead wrong.

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In truth, this kind of extreme volatility is killing the stockmarket. Companies can't list new shares when prices are bouncing around in such a crazy way. Ordinary investors watch the news headlines and despair of the markets. Some give up on stocks completely. Sure, regulators have been fretting for years about the way in which markets have become less and less stable. But now it is time they actually started doing something about it.

There can be little doubt that the markets have become more and more jumpy. JP Morgan has analysed the flash crashes' of the past 80 years. It defines them as a drop of 15% or more in the S&P 500 index in the space of a 15-day period precisely the kind of thing we saw last week. If you exclude the 1930s, such crashes were exceptionally rare. There was one in 1946, but then nothing until 1987. These days, though, they seem to come around faster than a new series of Big Brother.

True, there may be some perfectly good reasons why markets are more volatile. They are at the mercy of political decisions more than they were in the past. Will the US raise its debt ceiling? Will Germany accept it has to bailout the rest of the eurozone, or will it blow up the whole project instead? Those are the issues on which stock prices now hinge and, compared with questions such as how the economy performs over the next few years, and how corporate profits will turn out, they are very difficult to predict.

Still, the outlook for the global economy doesn't change by 5% day by day. As Andrew Haldane, executive director of the Bank of England, has pointed out, trading has been getting ever more frenetic over the past two decades. Turnover in the equity markets in the US has risen nearly fourfold in the space of a decade, he noted in a recent lecture. At the end of World War II, the average US share was held by the average investor for around four years. By the beginning of this century, that had fallen to around eight months. By 2008, it had fallen to around two months.

The growth of high-frequency traders who hold stocks for fractions of a second, exploiting tiny movement in prices has been explosive. As recently as 2005, high-frequency trading accounted for less than a fifth of US equity market turnover by volume. Today, it accounts for between two-thirds and three-quarters. In Europe, it accounts for more than 35% of the volume, and it is growing fast in Asia. Although those traders may be able to make money sometimes, at least it comes at a wider cost to the rest of us.

Indeed, it is destroying the stockmarkets that are vital to a healthy free market economy. After all, it is through the equity markets that companies raise the cash they need to build new factories, warehouses, and invest in researching new products. Without that investment, the economy isn't going to grow. It's only through listing their shares that entrepreneurs widen the ownership of their businesses and bring in new partners. Without that, they would just leave them to their children who would probably mess them up. Finally, it is the equity markets that allow ordinary savers to benefit from the growth of the corporate sector. They give everyone a stake in the system not just a few privileged insiders.

Yet hyper-volatility risks all that. Companies won't want to list, and savers won't want to invest. These aren't the kind of markets any sane person would want to be a part of. And regulators can't claim they are unable to reduce volatility. A short-selling ban, such as much of Europe imposed last week, is an extreme step (short-selling is a useful tool for investors, and a good way of disciplining companies). But maybe this time it is justified. Better still, high-frequency trading could be curbed. How about an extra stamp duty for anyone who holds a share for less than a week? Or a reduction in duty for holding it for more than a year along with a reduction in capital gains tax for holding it for more than five years?

All of those moves would make the stockmarket more stable. Yes, prices go up and down as events change. But if recent hyper-volatility carries on, there may not be a stockmarket left to worry about. Everyone will have given up on it.

This article was originally published in MoneyWeek magazine issue number 551 on 19 August 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, sign up for a three-week free trial now.