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“The key to making money in the stock market is not to get scared out of it.” – Peter Lynch, Fidelity Magellan Manager (1977-1990)
Since the Standard and Poor’s 500 reached its near-term bull market high on April 29, 2011, we have experienced highly volatile trading on a day-to-day basis. Through it all, the result is a loss of 14.4% for the index. Interestingly, the market is down 7.4% year-to-date, but the dramatic volatility has made it feel much worse.
It is nonsensical, distracting and scary to see the market plummet 5% one day and rebound 4% the next. But, after the worst recession since the Great Depression and two spectacular bear markets within recent memory, one cannot expect the market to peacefully progress higher.
Bespoke Investment Group tracks volatility in the form of “all or nothing days.” These are trading sessions where 400 out of the 500 stocks in the S&P 500 go up or go down. In other words, these represent days when stocks largely move in unison and with no direct connection to the underlying fundamentals of each individual company.
As you can see from the chart below, these herd events have been quite common over the last five years. During the strong bull market of the 1990s, such days were rare. They were even infrequent during the tech crash of 2000 to 2002 because that bear market was more specific to one sector and more isolated to the largest of the S&P 500 stocks.
According to a study that The New York Times performed, since the beginning of 2000, “price fluctuations of 4 percent or more during intraday sessions have occurred nearly six times more than they did” from 1960 to 2000.
Yet another measure of the inordinate volatility in recent years comes from Andrew Lo, a finance professor at the Massachusetts Institute of Technology. He found that 10 of the 20 biggest daily upswings and 11 of the 20 largest daily declines from 1980 through August 2011 have occurred in just the last three years.
And the volatility is not just in the United States. Over the last three months, the Morgan Stanley Capital International (MSCI) Europe, Asia and Far East Index of developed markets and the MSCI Emerging Markets Index have correlated 96% and 97%, respectively, with the S&P 500, reports CNBC.com.
Many commentators blame high-frequency trading – where computers buy and sell the same stock in seconds or less – for the extreme volatility. This argument has merit as experts estimate that about 60% of today’s volume represents high-speed trading. Suffice it to say, such trading is not helpful or productive.
However, the “uncertainty” that exists in today’s economy is the prime culprit for the crazy gyration of stock prices. After all, according to a recent Bloomberg National Poll of Americans, only 9% are confident that the U.S. will not slide back into a recession, while 72% of participants say that America is on the wrong course. And for the first time since early September 2010, sentiment gauges from both the American Association of Individual Investors and Investors Intelligence are registering more bears than bulls.
Further, the Conference Board reports that consumer confidence in August fell to a reading of 44.5, the lowest since 40.8 in April 2009. But, don’t let “uncertainty” fool you. According to Haverford Trust, consumer confidence is a contrarian indicator. As the below chart exhibits, extremely low readings bode well for future stock returns, while very high readings are a harbinger of negative performance.
Fidelity Investments found that from June 30, 1981 through June 30, 2011 the S&P 500 posted an average annual return of 8% in terms of price appreciation (not including dividends). But, investors who missed the best 5 days during this 10,950 day period saw their returns drop to 6.4%. If they missed the best 20 days (1.8% of the time period), their returns were reduced to 3.7%.
Although market volatility is heightened, it is not a new phenomenon. According to Ned Davis Research, going back in market history to 1928, the market swings in one direction by at least 10% once a year, by at least 20% once every three and a half years and by 30% once every six years.
Historically, the volatility associated with stocks has come with an upside in the form of higher returns. In other words, “uncertainty” is your friend. Think back to the spring of 2009, by most measures the last time investors were this gloomy about the future. Since closing at 676.53 on March 9, 2009, the S&P 500 has rallied a whopping 72% to close at 1,167 yesterday, excluding dividends.
Looking ahead, the present earnings yield (earnings divided by price) on the S&P 500 is nearly 8%, based on profits achieved in a difficult economic environment over the last twelve months. Compare that to the yield on a ten year U.S. Treasury bond of 1.875%. In locking-up our money for the next ten years, we know what our choice is . . .