Enjoying the ride? If you think the stock market has been more volatile than normal, you would be correct. The chart to the right shows that since 1940, the past 3 months have been abnormally volatile.
The question is, what does this mean to an investor?
First, lets define volatility. We define it as the day to day change in the stock market. It can either be up or down. For purposes of this report, we are using the Dow Jones Industrial Average and the data is supplied by Yahoo! Finance.
Looking at the chart to the right you can immediately see that the periods of high volatility tend to be spikes and do not last for a long time. (Although, while experiencing it, it can seem like it will last forever!)
Periods of high volatility are followed by extended periods of below average volatility. The black line is the average daily volatility since 1928. You can see that much of the 90 Day Average Daily Volume (red line) is below the straight black horizontal line.
An important point to note is that peaks of volatility are normally associated with market bottoms. So if volatility gets you spooked, you should remember that peak volatility is an indicator of bottoms.
I’m not saying that the current volatility indicates that the market is bottoming though, because the volatility could get worse, and the stock market could fall much further, as it did in 2008.
What I am saying is that those that are concerned about the market because of the current high volatility should look longer term, because calmer markets usually follow periods of high volatility. (I’m not saying we are at the peak of volatility yet!)
Looking more closely at volatility, the chart on the left shows the average monthly daily volatility since 2005. Volatility stayed low until it exploded higher in the Spring and especially the Fall of 2008.
Since it peaked in 2008, volatility dropped off considerably until it bottomed in late 2010. Since then it has been rising.
The causes of the volatility are debated within the investment community by both professionals and amateurs. We at Cornerstone believe that much of the instability in the markets is a reflection of the poor fundamentals in both Europe and America. A sound market doesn’t have the kind of swings we have seen recently.
The catalyst for much of the market movements have been headlines from around the world and at home. Greece gets a bailout, the market rallies, Unemployment in America rises, the market tanks.
Markets are supposed to be discounting mechanisms, which means these headlines shouldn’t be taking the markets by surprise sending it up 300 points one day and down 300 points the next. The markets are supposed to have information “built-into” the current price.
But investors and traders are so skittish these days that any news can be a market mover, one way or the other. This is not conducive to any kind of short term trading or short term planning of any kind. Thanks to the recent volatility, the stock market is acting more like a casino, than a place for serious investors to find good values.
New investor types:
Our observation of current investors are that they fall into three camps.
1 - The first are the experienced, savvy investors. They understand that the current volatility is short term and won’t last forever. It may even give some buying opportunities, but they recognize that this kind of market may be too dangerous to fool with. Sitting on the sidelines is a better bet than risking getting burned badly. They judge that in an environment like today’s, return of your money is more important than return on your money.
They know that this environment won’t last forever and have the patience to wait for the markets to eventually settle down. This, thankfully, may be the largest group.
2 - The second is the panic stricken. They are fearful of the volatility and want no part of it. This includes investors that aren’t even invested in the US stock market. They extrapolate the market volatility into their holdings, regardless of what they are. They see the nightly news and their fear of losing all their money blinds them to the reality of the potential for their current investments and strategy. It leads them to make bad long term decisions because of short term volatility.
3 - The third is usually the novice investor that sees only the up days. They don’t pay enough attention to the markets to see the down days and what the net is of all the volatility. Some actually think it is possible to invest on just the up days. (I’m not kidding, we had someone ask us if we could keep all his money in cash until about 10:00 each day and if the market was up, put all his money in the market until about 2:30 that day. At that point he wanted us to sell everything and stay in cash until the next day that the market was up by 10:00, when we would repeat the process over again. Needless to say, he isn’t a client!)
Many novice investors are not experienced enough to understand the risks in the current market and the risks in the Global economy. Equipped with a lack of wisdom and little to no perspective, they don’t get it that when the markets are volatile, but going nowhere (more on that later), with huge risks rising, it is better to be in preservation mode. They don’t believe that there will be plenty of time to make money once the markets settle down. Instead, they seem to think it is a measure of bravery to invest in the face of such high risks and volatility.
In-depth Analysis of Volatility
The first couple of charts in this report showed volatility, regardless of the direction of the market. In the next few charts, we will breakout the up days from the down days. It is very revealing and gives some insights as to why these new investor types have developed recently. 
The first thing we did was to separate the up days and down days and then we averaged the returns for each month. The chart to the right clearly shows that average daily gains and losses are greater, just since July. Those that are concerned about the market have good reason to be, since they are seeing average declines of as much as 2.69% per day.
Apparently, they fail to see that there have been average gains of as much as 1.48% per day. Focusing on the individual daily performance, or even the average of the daily performance doesn’t give the whole story though.
We were left with a few more questions. How did these relate to the monthly performance and how on many days a month did these declines and gains take place?
The chart to the right shows the total gain of the up days and the total losses for the down days plotted against the gain or loss for the month.
Here the results were very surprising. The market would have incredible gains and losses within the month, but much of it would cancel each other out, leaving the month with a moderate gain or loss. The market was going nowhere fast.
Obviously, if the gains totaled more than the losses, the month was up and if the losses totaled more than the gains the month was down. But, August’s up days totaled over 20% gain, while the month ended with a 4% loss. That doesn’t tell the whole story. The down days totaled about 24% loss, wiping out the gains for the up days.
This is important because some investors tend to watch just the up days while other investors tend to watch just the down days and neither puts them all together. How many people keep a running total of the market’s gains and losses in their heads?
It is almost understandable that an average investor won’t be paying attention to the market every day. So they may miss the down days or they may miss the up days. Depending on the person’s pre-determined attitude, they may only notice the up days if they are of that mind set or notice only the down days if they are particularly cautious.
We looked a step further to determine what are the likely news reports going to be, positive or negative? So we plotted the number of days (as opposed to the performance percentages in the previous charts) against the market performance and got the most surprising result of all. 
The chart on the left shows the number of up days minus down days vs the market’s performance. Only once this year has the number of days that the market has declined outnumbered the number of days the market has advanced in any given month. Yet, the market has been down five of the first ten months.
So what does this mean for investors? The overly bullish investors are seeing confirming information, most of the days the market is up. The fact that the performance of the down days outweigh the up days during those months when the market dropped is lost on the overly bullish.
The danger for investors is to over-react to the short term volatility. Many investors that are overly bearish may want to hide in the perceived safety of long term fixed instruments like annuities, long term bonds and bank CDs. We believe this is the wrong long term solution to a short term problem for many people.
If someone is concerned about the volatility, they can simply step aside into short term instruments such as money markets and short term bonds. This way they will still be liquid when the volatility settles back down and can get back into the markets with more confidence.
The long term strategy we prefer for the current volatility is to keep a long term perspective. Understand that peaks of volatility many times coincide with market bottoms, so waiting for that eventuality may be a good strategy. Looking beyond the volatility at the underlying fundamentals is also a smart long term strategy. Looking for opportunities created by the short term volatility is another good way of handling the volatility.
Making the volatility work for you, instead of against you is the idea. Trying to trade this type of market is dangerous. When the market is up 2 days, down the next, up 1 day then down 3, there is no predictability which is needed for successful short term trading.
Investors that want no volatility at all belong in cash, CDs, money markets and short term T-Bills. What they will give up is performance.
If however, an investor wants the potential for better performance, then they will have to accept some volatility. It is the nature of the beast. There are strategies that can limit volatility though. This is what Cornerstone attempts to do with the various strategies we deploy.
Today’s market volatility will eventually give way to calmer markets. It is the way it has always been. But the markets could drop further and volatility increase even more in the meantime. It is during these times that investors have to stay focused on the long term fundamentals of their investments and strategies and look past the short term volatility.
It is only then that they will be able to sit back and enjoy the ride.
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