Volatility is here to stay

While the U.S. economy is gathering steam as 2011 winds to a close, capital markets continue to show signs of volatility.

Over the past three months, the economic data has beat expectations by a healthy margin, yet the S&P 500 has essentially been flat.

Stronger than expected economic data typically generates a ‘risk-on’ environment, prompting a rally stocks and a sell-off in treasuries. However, the U.S. equity market remains largely tethered to Europe, gyrating around policy events in the region, according to Neil Dutta, economist at Bank of America Merrill Lynch.

After a brief break, the correlation of price movements between U.S. and European stocks has been climbing since early November.

“Early in the day while European markets are open, U.S. markets sell off as concerns about Europe simmer,” Mr. Dutta told clients. “After the European markets close, U.S. markets have a tendency to stabilize.”

With correlations on the rise, he said it is reasonable to assume that market volatility is also elevated. As a result, the normal trend whereby firmer data leads to stronger equity prices gets clogged.

So while many investors assume that once Europe shifts away from the forefront of market psychology volatility will return to more normal levels, Mr. Dutta isn’t so sure. He notes that the United States remains very vulnerable to shocks, particularly the “haphazard” domestic policy that will likely deliver more shocks in the coming year.