It was a breathtakingly volatile week in the equity market, even more remarkably so for the paucity of reasons for the wild fluctuations. A host of explanations were given, yet none were satisfying. In fact, stocks have demonstrated such outsized volatility surprisingly often in the past. For the most part, it is primarily noise. That’s why huge drops can be followed by dramatic rallies. Since the downdrafts can’t be anticipated, the key is taking advantage of them after they occur. This means using bonds or cash, if available, to buy, or swapping into securities that fell excessively, even though the natural inclination of most investors is to sell to get out of the way. As Warren Buffett said, “be fearful when others are greedy and be greedy only when others are fearful.”
Lots of reasons have been given for a slide in stock prices:
- The Fed is tightening policy. True, but rates are still very low.
- The economy is going into recession or is already in recession. Really? With the economy still hiring more than 200,000 monthly and more than 7 million job openings? GDP forecasts for the 4th quarter are almost all above 2% growth. Recession claims are simply fact deficient.
- Growth is slowing. Yes, since 3.5% GDP growth is unsustainable. Even 2% growth may be too fast, since it was sufficient to drive unemployment from 10% to less than 4% since 2010. Growth needs to slow to prevent the economy from overheating and driving inflation higher.
- Stocks are too expensive. Maybe FANG is expensive. But there are literally hundreds of stocks trading at less than 13 times 2019 earnings and more than 100 trading below 8 times 2019 earnings. Excluding FANG, the entire S&P 500 trades for less than 13 times. Stocks are cheap historically.
Why are stocks so volatile?
- Well, stocks are volatile. We’ve had two major downdrafts in 2018, but this isn’t unusual, nor are declines of 10%.
- Liquidity is low late in December, so small changes in buying or selling accentuate price movements.
- Retail investors are unusually nervous, since the political background is extremely contentious and nasty. The speed of trading with ETF access may increase volatility by making it easier to get in and out of the market quickly for the masses.
- Retail investors still suffer from the scars of 2008 and worry it could happen again, even though circumstances are very different.
- There is a major trade battle underway to level the playing field with China, so it is understandable investors are nervous while the issue remains unresolved.
- Trading levels seem to be driven by algorithms, not by investors. The machines jump on board to reinforce any trends that are underway, which adds to volatility. (Humans can take advantage of the machines by buying when the machines sell excessively.)
Investors need to recall they own a piece of the U.S. economy when they own stocks and their investment holdings will recover, even if the economy does lapse into recession. Recessions and stock market declines are normal, but are difficult to anticipate. So, investors must be prepared psychologically to live with such events. It helps to understand that most stocks are not lottery tickets that are at risk of becoming worthless. So they need to think like company owners and invest for the long term. Their holdings may fall in value in the short term, but in the longer term, their investments will grow with the economy. It is that growth that provides cash flows in retirement. Pulling out of the stock market to avoid volatility and to be safe also prevents those investors from participating in the growth of the economy or their portfolios from recovering after downdrafts. It may be difficult psychologically, but it is almost always time to buy when the market suffers a serious downdraft.