IS VOLATILITY Here to Stay?

• Author: Aggarwal, Raj
• Position: Stock market volatility

Human nature suggests that it is, says a professor at Kent State University. But there are steps that regulators and others can take to minimize it.

In recent years, we have seen the rise of the revolutionary Internet-based "New Economy" and, coincidentally, a significant rise of economic and financial volatility, with more frequent bubbles and crashes in asset prices. Is there a relationship between these two developments?

The answer is important, as these short-term but sharp economic and financial cycles can often wreak havoc on an economy. The Japanese economy has still not recovered completely from the bursting of its price bubble more than a decade ago; and with the bursting of the United States' technology stock bubble in 2000 -- in spite of monetary easing efforts by the Federal Reserve Board -- economic growth in the U.S. has slowed sharply from its recent peak of 8.3 percent annual rate in the fourth quarter of 1999. The economy remains vulnerable to a recession, and following the Sept. 11 terrorist attacks, many economic forecasters predict one.

Interestingly, prior episodes of major technological change have also been associated with increased economic and financial volatility -- railroads in the late 19th century, radio in the early 20th century and electricity in the 1920s. In each of these prior "tech revolutions," there was a great outpouring of capital for large numbers of entrepreneurial companies; and while a lucky few made a great deal of money, most of these companies did not survive, and the average investor was left with huge losses. Each new technology has been associated with much uncertainty and, in each case, it's been hard for investors to differentiate between good and poor investments.

So it is with the current Internet revolution. After spectacular increases in the prior few years, Nasdaq stocks dropped by a third in 2000, and by another third by August 2001. Internet and other tech stocks suffered even larger drops, most of them sudden. For example, when Hewlett-Packard Co., a company growing over 15 percent annually, announced that it would miss expectations of its fourth-quarter 2000 earnings by a few pennies, the stock lost $23 billion in three days. It was the same for old economy companies. One day after it made a similar announcement, Home Depot's stock fell by 29 percent, a loss of S32 billion in value.

Other instances of similar strong one-day market reactions to downward revisions in earnings...