The Two-by-Four Link to Stock Volatility

A correlation with building permits suggests worry about market torpor may be overblown.
Photographer: Scott Olson/Getty Images

The reason for the stock market's vanishing volatility may not be what many people think. It may have more to do with local community boards or town reps than the Federal Reserve. 

Volatility, which has slumped this year, has been a big topic of discussion among market participants, and not all of it has been positive. Low volatility is usually seen as a good thing -- a sign of investor optimism. The VIX, which tracks volatility, is often called the market's fear gauge. But the all-time lows in volatility has some market watchers and economists scared that investors aren't worried enough. Former Fed Governor Kevin Warsh said in May that low volatility was his No. 1 concern. Warsh and others have said low interest rates, which have been rising recently, have bred complacency.

Vanishing Volatility

Market watchers have been worried that the drop in the VIX means investors have forgotten about market drops

Source: Bloomberg

But the bears, and the bulls, may be reading too much into the the drop in volatility in part because of a surprising historical contributor. That's where a new working paper published by the National Bureau of Economic Research this month comes in. The paper looked at the Great Depression, when stock market volatility, unlike today, was spiking. That coincided with a number of boom-and-bust building cycles. Gustavo Cortes of the University of Illinois at Urbana-Champaign, one of the paper's authors, looked at more recent data, up through May, and found that the relationship still holds -- when building permits are volatile, the stock market tends to follow suit.

Recently, building permits have been relatively weak. The number issued nationwide, 1.2 million in May, has been trending down and is still way below where it was at the height of the 2000s building boom, when it peaked at 2.3 million a month. That could could make the low volatility a data point for the bears. Building permits have traditionally been seen as a leading economic indicator.

A Less Than Robust Rebound

Construction has snapped back from the housing bust is still not back at the level it was before the bubble

Source: U.S. Census Bureau

But the weakness in building permits is generally not new. Stricter zoning laws have generally dampened sharp swings in building permit growth over the past few decades. The one exception is the housing boom and bust of a decade ago. But that, too, is most likely having a moderating effect on housing. "Given all the positive economic factors in play right now, you would have expected a bigger rebound in construction," says Frank Nothaft, chief economist at real estate data company Corelogic. "Zoning and land use rules are probably having an effect, as well as the availability of labor and credit."

A Great Moderation

Housing booms and busts have generally moderated over the past five decades

Source: U.S. Census Bureau

And that might be a point for the bulls. Restrained housing booms and busts carry over into the economy. If the drop in volatility truly reflects one that is less susceptible to overheating, rather than just evidence of investor base that has forgotten that it can, the recent fear about the drop in the VIX might build to nothing.

(Corrects the spelling of the surname of former Federal Reserve Governor Kevin Warsh in the second paragraph.)
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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