Volatility – When to be Nervous and When to be CalmNovember 9, 2015 5:25 pm
Now that the August/September swoon has passed and the markets have recovered their swagger, I can talk about volatility without sounding alarmist.
Volatility is simply the relative rate of price change, meaning how far the price of an asset moves from a particular reference point. Volatility can be low (small moves) or high (dramatic moves) and it reflects both increases and decreases in price.
JP Morgan Asset Management calculates the intra-year drawdown, one measure of volatility, for the S&P 500 between January 1980 and September 2015 as 14.2%. “Intra-year drawdown” is the amount stocks fall at some point during the calendar year before turning around and rising again. So in 1980, while the stock market ended up on December 31st by 26%, the intra-year drawdown was 17%. Imagine the worry that investors might have felt when they saw their equities drop midyear. If they panicked and sold as the market tanked, they would have missed out on hefty gains overall by year end.
In 2015 the drawdown has been 12% (May 21st to September 29th), most of the decline happening in August and September. As of Friday, only the Nasdaq has fully recovered from the May low; S&P 500 and Dow have regained most of the lost value. That does not mean that we won’t experience another drawdown before the end of the year. We very well could, and this one could be greater or lesser than the one we just experienced.
A typical year on average witnesses a one-time 10% decline in equities; a 5% decline once each quarter; and a 3% decline monthly. A true bear market (greater than 20% drop in the market) usually occurs only once in a business cycle – and is often associated with a recession.
So if volatility is normal, why does it always feel so scary?
When markets fall there is a tendency to provide a reason for the decline through a story or an explanation. In August, the primary story was China and the fear that a slowdown in its economy could weigh on the rest of the world, including the US. Given that the story wasn’t new and that economic data shows the US to be relatively immune from China’s export/manufacturing/structural woes, the explanation was ephemeral, although most people didn’t know that. The same held true in September when the biggest story was the Federal Reserve’s decision to hold interest rates steady. Again, not a new story, but it unnerved the markets at least temporarily. Like the China explanation, the power of the story faded.
What doesn’t come across in the press is how often technical factors play a role in volatility. For instance, momentum traders can leverage (borrow money) to magnify their bets. Getting caught going the wrong way can force a rapid unwinding of trades, sending markets down fast. So too with investors who follow the crowd and put money into one sector or asset class. When the popularity fades, the herd can suddenly turn and run in the opposite direction, dumping holdings (and anything that remotely looks like the reviled security).
Then there are the high frequency traders (HFT), who are really computers completing trades in fractions of a second in order to take advantage of pricing discrepancies. HFT along with program traders, who follow mathematical algorithms, are frequently cited as being responsible for between 50% and 70% of all trading, especially as it relates to exchange traded funds and equities. When they come together, the market descent can be meaningful.
At the same time, some traders follow the charts, which can provide signals to buy and sell holdings independent of the underlying fundamentals, compounding a loss or a gain.
Sometimes volatility is a signal for much deeper problems. When should you be concerned?
Here is a short list of some of the red flags investors should look for when analyzing whether a down market has sustainability:
- Signs of a recession – high inflation and interest rates, peaking or slowing demand for products, and an inverted yield curve with short term interest rates exceeding long term rates. These factors are often evident prior to a recession. Currently none is a threat, although demand – as expressed in company revenues – is lackluster.
- Asset bubbles – such as in technology stocks in 2000 or housing in 2006 and 2007. Equity valuations are currently high but not bubbly. That means the upside may be limited, but it doesn’t necessarily signal a bear market is in the making. Stocks can overshoot their fair value for a long time before reverting to the mean.
- Unhealthy banks sporting too much leverage and risk – think 2008. Fortunately, US banks are being monitored more closely and have been required to reduce their leverage and risk exposure. A credit crisis, similar to the one we experience in 2008, is unlikely in the US at this time.
- An unexpected shock from outside the investing markets – perhaps associated with geopolitical risk or natural disasters. Although there is always a chance for an exogenous event to occur, these can’t be predicted. Investors should be prepared to react but not panic when these factors occur.
Experiencing volatility can be an uncomfortable part of investing, but it is normal. Sometimes when the markets experience a period of calm, we forget how jarring a loss to one’s portfolio can be. Before reacting suddenly, however, to ease the pain, investors are often better off stepping back and analyzing whether the cause is short-lived or something more substantive.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.