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Stock Market Volatility: You Ain’t Seen Nothing Yet

By Jim Fink on October 28, 2010

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There’s nothing like a good challenge to inspire you to your best performance. The competitor in me is unleashed and I vow to either win or die trying.

Elliott Gue, Stocks on the Run

I love roller coasters. Speed combined with acceleration and 100-foot drops at a 90-degree angle give me a good rush. But the important thing is that it’s safe. In contrast, there is nothing safe about stock market declines. Hard-earned money that disappears in a market downdraft is no laughing matter. As I wrote in The Great Investment Truth, investment losses are much more damaging than gains are beneficial, so buy-and-hold portfolios that avoid extreme volatility (specifically, the downward kind) will likely generate significantly greater wealth than those that experience a roller-coaster price trajectory.

Volatility is Increasing

Unfortunately for buy-and-hold investors, the stock market is a very volatile place and indications are that it is only getting more so. Another word for volatility is “standard deviation,” the average percentage rise or fall in price that has occurred over a 12-month period. If a stock index is trading at $100 and had a 20% annual volatility, over the past year the index has probably traded in a range between $80 and $120. The greater the volatility, the greater the price range.

Take a look at the following chart showing the 36-month moving average of the S&P 500’s historical volatility. Looking back to 1996, the stock market’s annualized volatility is at an all-time high:

Source: Bloomberg

When you think about it, this is an amazing fact. Neither the once-in-a-lifetime Internet bubble between 1997 and 2000 nor the stock market crash that occurred afterward from 2000 to 2003 were as volatile as the three-year period we have just experienced from 2007-2010.  And the volatility chart shows no signs of having peaked yet!

Ben Bernanke and the Fed are Playing a Dangerous Game

Why could the future stock market be even more volatile than what we have experienced so far? One word: Ben Bernanke. The chairman of the Federal Reserve is causing the mother of all asset bubbles with his zero-interest-rate policy and his decision to flood the world with trillions of U.S. dollars through quantitative easing. Money manager and economics Ph.D John Hussman says this line of action is creating a very unstable economic situation:

Quantitative easing promises to have little effect except to provoke commodity hoarding, a decline in bond yields to levels that reflect nothing but risk premiums for maturity risk, and an expansion in stock valuations to levels that have rarely been sustained for long (the current Shiller P/E of 22 for the S&P 500 has typically been followed by 5-10 year total returns below 5% annually). The Fed is not helping the economy – it is encouraging a bubble in risky assets, and an increasingly unstable one at that. The Fed has now placed itself in the position where small changes in its announced policy could have disastrous effects on a whole range of financial markets. This is not sound economic thinking but misguided tinkering with the stability of the economy.

Similarly, legendary money manager Jeremy Grantham has just released a new market commentary (free registration required) entitled “Night of the Living Fed” that compares Bernanke to a flesh-eating zombie that is killing the U.S. economy.  He writes:

Adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.

Get Ready for an Up and Down Stock Market

Despite this negative long-term assessment, Grantham sees the current stock market rally extending into 2011 as the speculative bubble accelerates in the third year of the presidential cycle prior to imploding:

For good short-term momentum players, it may be heaven once again. I expect that the bottom line will come down to short rates. Surely they will stay low for the entire Year 3. If so, the “line of least resistance” is for the market to go up and for risk to flourish. In the last six months I’ve guessed on separate occasions that levels of 1400 or 1500 on the S&P 500 are reachable a year from now. Risks to this forecast: the Fed is also stirring up a hornet’s nest on the currency side of this issue with its quantitative easing.

There is also the definite possibility that we could slide back into a double dip, so we may get lucky and have a chance to buy cheaper stocks. But probably not yet. And, of course, if we get up to 1400 or 1500 on the S&P, we once again face the consequences of a badly overpriced market and overextended risk. And this time the government’s piggy-bank is empty. It is not a pleasant prospect.

Sounds to me like Grantham is expecting the stock market to enter a roller-coaster period where it first goes way up, crests, and then starts to fall faster and faster. What industry sectors are most likely to benefit from the upcoming speculative run-up? Grantham gives the nod to natural resources such as energy, metals, and food:

I really believe that we are in a new world in which we are running out of resources … a world that only China truly gets. My personal advice (i.e., how I invest my sister’s pension fund) is to give the benefit of any doubts for very long-horizon (20 years) investments to resources in the ground. Resource stocks, though, have really run, and a serious price decline caused by, say, China’s stumbling, would of course make for a much better entry point.

Stock Correlation is at a Record High

As I wrote last month in Macro Investing, the Fed’s massive tinkering with the economy has led investors to care less about individual stocks and more about a binary trading system of either “risk-on” stock exposure or “risk-off” U.S. treasury and cash exposure. This has resulted in a significant increase in the correlation between stock indices and their individual stock components.  Birinyi Associates recently issued a report stating that at the end of September stock correlation hit an all-time record high of 63%, almost twice the 30-year long-term average. 

Does this mean that good stock picking is no longer important? Far from it!  As one of the authors of the Birinyi report stated:

Specific stock selection is more crucial now than ever. While the vast majority of stocks are acting as one group, there are still many examples of the so-called ‘home- run,’ and finding one or two of them will generate significant performance for your portfolio.

Stock Picking Talent Still Matters

Keep in mind that correlation just measures similar direction; it does not measure magnitude. Consequently, a stock with a high correlation to its relevant index can still outperform the index by a significant amount.  For example, engine manufacturer Cummins (NYSE: CMI) had an amazingly-high 83% correlation with the S&P 500 over the past year and still managed to outperform the index by 94 percentage points!

Of course, stockpickers that can find the increasingly rare stock that zigs up when the indices zag down will continue to perform very well. For example, Internet tech company Akamai (NasdaqGS: AKAM) had an extremely low correlation of 22% and yet beat the S&P by the same 94 percentage points.

Bottom line: stock picking talent still matters.

Stocks on the Run is the Perfect Advisory for a Roller Coaster Market

KCI’s own Elliott Gue and Yiannis Mostrous, two of the most talented stock analysts on the planet, offer a short-term investment service based on a competition between the two of them. Competition is sure to bring out the absolute best stock-picking performance these superstars have to offer.

Each month they pick a single stock primed to score big in the next three to nine months. No “value trap” stocks that require years to play out; only timely recommendations that possess the earnings momentum, price momentum, and/or “catalyst” to make a big move NOW.  

Yiannis and Elliott are both top-down investors who study business cycles and have honed to perfection when to get in – and out of  — industry sectors for maximum profit. Catalysts are one of Elliott’s favorite buy triggers.  As he wrote in an advisor roundtable:

When researching growth-oriented companies I look for catalysts. There’s no point in buying or selling a stock that’s just going to trade sideways or follow the broader market in lockstep.

Protect Your Portfolio with Stocks on the Run!

A roller-coaster market is no place for buy-and-hold investors. The only way to win in a high-volatility stock market where huge winners can turn into huge losers overnight is quick and nimble trading that takes advantage of sharp moves but gets out before the party is over.

If you are looking for a short-term service that can spice up your investment returns with some quick winners, Stocks on the Run is just what the doctor ordered. Right now, Gue and Mostrous are recommending a metals and mining powerhouse primed to deliver double-digit gains as part of the natural resource speculative run-up that Jeremy Grantham is forecasting.

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