Understanding Stock Market Volatility

One of the most prominent features of the U.S. stock market is the close connection between aggregate stock market volatility and the development of the business cycle. Figure 1 depicts the statistical relation between stock market volatility and the industrial production growth rate over the last sixty years, which shows that stock volatility is largely countercyclical, being larger in bad times than in good times. Understanding the origins and implications of these facts is extremely relevant to policy makers. Indeed, if stock market volatility is countercyclical, it must necessarily be encoding information about the development of the business cycle. Policy makers could then attempt at extracting the signals stock volatility brings about the development of the business cycle. In this short essay, I accomplish three tasks. First, I review and uncover a few stylized facts about stock market volatility, arising within a business cycle perspective (in Section 1). Second, I seek for theoretical explanations of these facts (in Section 2). Third, I investigate whether stock market volatility contains any useful information about the evolution of the business cycle (in Section 3). There are other exciting topics left over from this essay. For example, I do not tackle statistical issues related to volatility measurement (see, e.g., Andersen, Bollerslev and Diebold (2002) for a survey on ∗This paper is a substantial revision of a previous article titled, “Understanding Stock Market Volatility,” which appeared in the Financial Markets Group Review, London School of Economics 67, 10-15 (October 2005). In writing this essay, I have greatly benefited from the many discussions with my co-authors working on projects related to the topics dealt with in the essay: Valentina Corradi, Walter Distaso and Fabio Fornari. I am also indebted to Andrew Patton for his comments on the very first draft of this paper. I thank the British EPSRC for financial support via grant EP/C522958/1. The usual disclaimer applies.