Vexed by Volatility

Though June was the first month this year to end with a loss – the S&P 500 closed down by just 1.4% – we still wound up with nicely positive results for the quarter and year-to-date for each of the three leading stock market indicators. Matter of fact, it was the best first half of a year for the Dow since 1999 and the best first half for the S&P since 1998.(1)

On the other hand, gold had its worst quarter ever, going back to when records started being kept in 1970. It’s down $450 an ounce since year-end and was off 24% just in this quarter.(2)

“It’s the Bottom for Stocks” / “Correction Not Over in Market”

While I, personally, believe the former to be the more accurate statement, that’s not why I chose these two. On Friday, these two headlines, linked to the stories supporting those differing points of view from two well-regarded investment pros, ran one right above the other on the CNBC home page. I guess you could say that these two perspectives give you a look at just how uncertain the general attitude about the market is currently. Not that this is an unusual occurrence. It is, as is said in the investment business, what makes markets. Somebody is always a seller and someone else, the buyer. The two opinions represented lead to regular and daily market fluctuations; a term, I believe, much more accurate for the daily market moves as it means, “to vary irregularly.”

Also on Friday, and again on the CNBC home page, there was another headline stating, “Buckle Up! Expect More Market Volatility This Year.” when the market seems focused on primarily buying or selling, it can create a volatile situation. So, why has volatility come to have, basically, only a negative connotation?

Let’s consider that.

Definition

In the context of investing, and according to Investopedia, volatility refers to “the amount of uncertainty or risk about the size of changes in the value of a security.” A higher volatility means that the price of the security can change dramatically over a short time period – in either direction. A lower volatility means that a security’s value doesn’t fluctuate dramatically, but at a steady pace over a period of time. So, volatility is neither good nor bad – it’s an is…

What I’ve found to be a challenge in dealing with investors is that, over the last 20 years or so, the media has trained most people to assume that volatility is a bad thing; that it only goes one way and that way is a loss. If that were true, the stock market couldn’t go up, could it?

Market volatility (and fluctuation) is a normal feature of bull markets. Bear markets tend to simply move lower as there is an absence of bids to stir things up. Even when market fundamentals are strongest and most positive, stocks never move up in a straight line. Fiscal cliff diving, sequestration, tapering – whatever the “critical” stories of the day may be – can give investors the heebie-jeebies. That fear can often trump fundamentals…at least for a short while. As Benjamin Graham once said, “over the short-term, the markets act like voting machines. Over the long-term, they act like weighing machines.” A voting machine measures sentiment / popularity. Assessing weight is a measurable, fundamental fact. Sentiment and emotions are volatile, subject to what’s going on right now and that gets transferred into the markets.

Why so fearful of volatility?

Blame our ancestors. We’re wired to perceive pain incurred from loss much more than the joy derived from similarly sized gains. There’s even an index that’s been created called the Market Volatility Index or, more familiarly, the VIX, which is based on it. The index can be traded daily and is often referred to as either the “fear index” or “fear gauge.” High readings mean that investors see significant risk that the market will move a lot – up or down. (3)

Yes, volatility could – eventually – lead to a loss. I believe this seemingly default thinking has a lot to do with the fact that this recovery has been so demeaned, even in the face of the reality of its happening. The memory of 2008– 2009 bear market, even five years later, still counts for more in their personal voting machine than does the bull market…even though the recovery is now greater than what we lost to the bear.

And yes too, the 2008 bear market was a big, bad one – but it was also highly unusual. Since 1926, when the S&P500 first came into being, 2008 was one of only three calendar years over that entire period that the S&P 500 fell by more than 30%. Put another way, such big falls have happened only 3.4% of the time over 87 years. (4) However, since that one occurred most recently, it makes us feel we should expect them more often. Can it happen? Sure! Is it strongly probable? I don’t think so.

On one hand, since1926, stocks fell in 24 calendar years. However, in half of those years, returns weren’t down all that much – less than 10%. On the other hand, over this same time period, big market gains have occurred more than losses of any size. The S&P 500 has been up 30% or more eighteen times – more than 20% of the time. Further, gains of 20% – or more – have happened 32 times; 36.8% of the time. Basically, the markets are higher about 7 years out of 10. (5)

Investors often sit on the sidelines fearing that (one-way) volatility will cause them to experience “the next big loss.” And yes, we’ll get drops over time. (We’ve had 11 recessions since World War II…and have seen the S&P rise from 18 to 1600.) (6) Sometimes, like in 2008, they could be big. But what comes in between the drops? Lots of upward markets…

Summary

Market moves can be disconcerting and even scary. Right now, with our economy transitioning to that proverbial next level, with the Fed adapting, we could expect more choppiness, noise and erratic trading leading to periods of higher volatility as the market continues to deal with the prospects of the implications of a less accommodative policy. In my opinion, for the longer term, this sort of move is not only necessary, it’s healthy. Near term, it can prove to be uncomfortable from time-to-time.

Nevertheless, not investing seems to fly in the face of history and reality. Worse, it can also increase the odds of lower returns on your invested assets than you could have by staying with a disciplined strategy over time.

Lloyd Blankfein, CEO at Goldman Sachs, had this comment Friday that I think fits this topic. He said, “Sentiment has a real effect. This (investing) is not natural science. It’s a social science, so sentiment and people’s feeling really matters in this thing. Confidence really matters.”

Be confident in the markets and your ability to benefit from their volatility over time. Volatility of pricing is the risk you take to get the rewards that you have seen demonstrated in the S&P since 1945…

Cheers and Happy 4th of July!!

Mike

509-747-3323

1.   CNBC, 28 Jun 2013

2.   Ibid.

3.   CBOE.com/VIX

4.   Global Financial Data, 17 Jan 2013

5.   Ibid.

6.   Nick Murray July monthly market comment

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Past performance is not indicative of future returns. Investing in securities of any type involves certain risks, including potential loss of principal. Investment return and principal value in a bond and/or securities portfolio will fluctuate so that investments, when sold or redeemed, may be worth more, or less, than the original investment.

Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

Michael J. Maehl, CWM®

Senior Vice President

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