Volatility is the usual outcome of this state of high uncertainty. If you want a validation of high volatility in the stock market, you should follow the behavior of the S&P VIX. It can go up by 50% in one week as happened in the week one the S&P rating agency downgraded the U.S. sovereign debt from AAA to AA+.
But what is the mechanism of this high volatility in the stock market? I think it's the bears are ambushing the bulls. As soon the stock market gets a bad hit by the bears, the bulls go fishing for "cheap bargains". They buy and push stock price higher in a very short time. The bears know that stocks are not cheap. At current valuations, the normalized P/E (normalized over the past decade) is 20 which is the long run average. this is not a bargain. It is possible that the bulls are focusing on the forward P/E which is about 16. this may entice buying.
It seems that the bears are better informed. They think that future profits are slowing because the economy is slowing. So the forward P/E ratio in the eyes of the bears is likely to go up. Combine this with the normalized P/E, stocks in the eyes of the bears are not a bargain.
The bears wait for the less informed bulls to fish for "bargains" and move the stock prices up and much higher than fair values . The stocks become overpriced. Then the bears attack and bring the prices to their fair valuations.
It seems that this process is repeated every week: the bears outsmart the bull weekly!!! But this process is dangerous. it intensifies volatility and this process may end up in a mega correction.
Are the informed bears telling us that the recession is coming? The August data show that the economy is deteriorating fast. In fact, business economists in the United States now believe that the probability for recession is 30%, up from 14% few weeks ago. As optimistic as I am about many things, I now believe the probability of recession is greater than 30%.
These are difficult times. Prudence is golden these days.
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