UNDERSTANDING VOLATILITY WILL KEEP YOU FOCUSED ON YOUR LONGTERM GOALS
By Christopher Clark in Trusted Advice
Market volatility or the daily and weekly market ups and downs is a measure of market risk. Nowadays, with multiple business channels vying for viewership, alleged increasing volatility is used as a tease to draw viewers. In addition, new investing instruments and a change in market structure have contributed to bursts of volatility that are very short lived and in-actionable and should be ignored as noise by the long-term investor. Understanding what and who is driving volatility, and its brevity is critical in keeping your fears in check and your long-term strategy intact.
With the volatility index (commonly known as the VIX) at historic lows, (see chart) it hasn't stopped the breathless reporting of increased market volatility over the past year or two. A few weeks ago, a business reporter on CNBC excitedly exclaimed that "we have BREAKING NEWS: this is the fifth day in a row the Dow Jones Industrial Index has had a triple digit move!". To put that in context, with the Dow at a level near 18,000, a triple digit move equates to little more than 1/2 of 1% and is a fairly common occurrence, not something worth stop-the-presses sort of reporting. In addition to the theatrical reporting style of high probability/frequent market events, the media will also trot out an industry professional with a perspective or theory that is of very low and sometimes almost zero probability and not frame it as such, all in pursuit of higher ratings to drive advertising sales. So, whether you are an investor in Chester or Hoboken, NJ, or Dallas, Texas, it's important to remember that even business shows look to drive viewership and advertising sales by sensationalizing the news.
Beyond the titillating reporting style of business TV, recently there have been structural changes in the financial markets, along with the introduction and proliferation of new investment vehicles over the last several years that facilitate the quick drop or occasional freefall (called a flash-crash) of market indices. As an example, the passage of the Dodd-Frank financial reform bill has essentially eliminated bank and broker proprietary trading desks. In the past, these trading desks would routinely commit large chunks of company capital to buy or sell large blocks of stock and provided a natural buyer or seller in size of US stocks. Also, technology has introduced algorithmic trading that is done by a computer program that requires no human engagement. Some of these programs actually automatically read the words in the headlines and news stories released throughout the day looking for a proliferation of positive (beat, raising expectations, strong etc.) or negative word flow (slowdown, disappointing, miss, slowing etc.) to initiate large buy or sell programs of the market indices or their subsectors. There are also programs that utilize breaches of technical patterns in stocks and indices to initiate sell or buy programs in an effort to prompt or rattle the traditional long-term investor into action. Beyond trading initiated by machines, you have the proliferation of Exchange Traded Funds or ETFs. ETFs trade intraday, and have become a preferred method of investing for institutional investors. These ETFs can reflect a group of stocks within a sector or sub-sector in the market, a whole index, and even an inverse of an index or a multiple of an index or market sector. With this expansion in ETF offerings, managers can rotate out of a sector and into another sector with just a few clicks of their computer taking them from fully invested to market neutral in a matter of seconds. ETFs now dominate the market volume, and with their use, a broad brush stroke is applied to an index or market sector (healthcare, financials, biotech, consumer staples etc.) where even the best stocks or worst stocks get dragged along in the short term action without regard to the stories behind the individual companies. Additionally institutional money managers have time horizons that are far different from the long term investor. Strategies can be designed to last a few hours, a few days or perhaps a few weeks. This has certainly increased the rotational aspect and freefall effect within the market itself. From our perspective, the broad uses of ETF strategies by managers has strengthened the opportunity to offer outperformance to clients via proper stock selection in the assembly of portfolios, as we keep our eye on long-term themes and client's long-term horizons.
As asset managers, we keep our clients' long-term goals in mind, and filter out the noise around volatility with an understanding of what and whom is driving it, as well as the term of the volatility. We hope that this helps your understanding of some of the forces behind the hour-by-hour and day-by-day market movements and allows you to stay focused on your investment objectives. Remember much of the media hype should be treated more as entertainment as opposed to actionable information.