Thoughts on Market Volatility

Thoughts on Market Volatility

Someone asked me a week or so ago whether I thought the market was going to crash. My answer was, "No." Then I added, "A correction is overdue, though, and when it comes, it will feel like a crash for no other reason that it has been so long since we've had one." We've been talking for more than two years about the unprecedented lack of volatility in the stock market, especially in light of the volatility in almost every other tradeable market. That seems to be over now. Stocks traded lower by three percent on Friday. That was the first three-percent-plus move we've had in four years. Put in perspective, we had 46 three-percent-plus moves in the four-year period prior to that.  
 
There will be a lot of coverage in the financial media about what exactly caused the sell-off, but the fact is nobody knows, nor is it important. I've seen the slowdown in China, the collapse of commodity prices, and the Fed ending it's stimulative interest rate policy all given as reasons for what happened last week. The fact is, none of that is new. China has been slowing for years, commodity prices have been falling for more than a year, and the Fed has been talking of raising rates since last October. Other than something like 9/11, or the tsunami in Japan, there is never really a single trigger.
 
Stocks have been expensive by every fundamental measure for the past year. But those measures are not trading signals. Markets can continue upward in spite of that if momentum is upward and liquidity is ample. It won't matter until it matters, and then, it will be all that matters. Then everyone will look back and say how obvious it was.  
 
More recently, bond spreads have been widening, which is a sign in that market that risk is being taken off the table. The majority of stocks had stopped going up and had reversed lower. As we said in last month's newsletter, "leadership in the stock market by fewer and fewer participants has been a warning sign in the past. Overvalued sectors tend to give up gains relative to the laggards, rather than the other way around. The last time the New York Stock Exchange's advancing-stocks-to-declining-stocks ratio fell this much, the broader S&P 500 dropped more than 19 percent. It occurred in July 2011."

Patience is your enemy in a bull market, but is your ally in a bear market. When oil traded down this Spring, negative sentiment got so one-sided that its price bounced back 20 percent before selling resumed. I expect we will see similar action in equities before the whole move is played out. Barring an economic recession in the U.S., we shouldn't see a repeat of the carnage of 2008. The financial sector is in much better shape now.

One of my favorite Warren Buffet quotes is, "Price is what you pay, but value is what you get." We will happily sit back and watch short-term traders and fund managers duke it out. Volatility and market corrections are healthy. Stocks have historically returned almost twice as much as bonds precisely for this reason. The chance of short-term price declines is why stocks will have a higher return over the long term. If your risk tolerance is aligned with your investment time horizon than stocks going "on sale" should be a welcome event.

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