A Love Affair with Volatility

Risk means different things to different investors.

Some calculate how much of their total portfolio they have invested in any given asset. Some look at the beta of a stock (which quantifies how volatile it is, relative to the S&P 500).

Me…?

I consider time when I think about risk.

Think about it…

If your investment strategy requires you to hold positions for five to 10 years… how much could change – or worse, how much could go wrong – during that time?

I’d say “a LOT” and “too much” – particularly when compared to an investment strategy that only requires you to hold positions for two to three months.

Conventional wisdom suggests that “traditional” investors are in it for the long haul. They buy and hold for years, even decades.

This strategy can work. But it leaves passive investors without anything to do when markets “misbehave,” so to speak. When volatility hits, buy-and-hold investors see it as the enemy. They simply can’t do anything to adjust their sails, so they just have to wait out the storm and hope for the best.

Psychologically, weathering volatility as a buy-and-hold investor is torturous. And studies show that most investors can’t handle volatility. We reach our “uncle” point too soon… we panic sell… and we severely underperform what buy and hold should have provided us.

But for flexible investors… volatility is a GOOD thing! Let me explain…

Until recently, stock market prices moved with very little volatility.

For weeks, market analysts on social media had been commenting about how quiet the stock market was. First, it was “30 days without a move greater than 1% on the S&P 500,” they noted. And then it was 35 days without a big move… and then 40 days…

The day-by-day countdown – “nothing scary happened again, today” – was a bit unsettling. It was almost as if these analysts were taunting the market gods.

And then Fed President Eric Rosengren warned that “financial instability” is at risk if interest rates are kept anchored for too long. (Thanks, but I’m pretty sure everyone’s known that for quite a while now!)

Despite his comments being in line with the Fed’s typical modus operandi – that is, warning the market of a rate hike… but not doing it – financial markets around the globe sold off in unison as fair-weather bulls rushed for the exits.

All told, the S&P 500 closed down 2.5% that day (September 9).

And with that, the financial media proclaimed: “Volatility has returned!”

Remember, buy-and-hold investors hate volatility. To them, volatility is the enemy. Volatile = “risk.”

But here’s the thing…

For flexible, short-term investors… sharp sell-offs and spikes in volatility are actually great buying opportunities!

Three of my Cycle 9 Alert research studies show that the recent uptick in volatility is a GOOD thing for stock prices. The statistics suggest we should see outsized stock gains in the months ahead.

Study #1 – Following a one-day sell-off worse than 2.5%

The S&P 500 lost 2.5% on Friday, September 9. Going back 25 years, a one-day sell-off of that magnitude has happened 50 times, or twice a year on average.

If you had bought the S&P 500 after each one of those -2.5% days, you could have earned an average profit of 2.1% over the next month… 3.7% over two months… and 4.5% over three months.

Those gains trounce the market’s average one-, two- and three-month returns (of 0.6%, 1.0% and 1.9%).

Study #2 – Following a VIX spike of 50% or more

On September 9, the Volatility Index (VIX) spiked 57% above its three-month low. That’s happened about 85 times in the last 25 years, or 3.5 times a year on average.

And while a volatility spike of that magnitude is certainly scary and painful to live through, buying stocks immediately after a spike has historically been the right thing to do.

Stocks have tended to gain 0.9%, 1.7% and 2.2% in the one, two and three months following large VIX spikes. Again, these stock gains beat the market’s average tendency, showing it generally paying to be bullish after short-term bursts of volatility.

Study #3 – More than 80% of stocks are below their 10-day moving average

As I said earlier, more than 70% of all stocks are still firmly above their 200-day moving averages. That means their longer-term trends are still positive.

But the opposite is the case for shorter-term trends. Currently, more than 80% of all stocks are below their 10-day moving averages. Historically, that’s a signal that investors are too pessimistic… and that stocks have sold off too far, in the short-term.

Stock market gains of 2.2%, 3.2% and 3.5% have followed this signal over one, two and three months.

So no matter how you slice it, the historical statistical evidence is clear: it generally pays to be bullish following short-term market sell-offs and large spikes in volatility.

Here’s a chart that shows this conclusion graphically:

For the signal returns above, I’ve simply averaged the result of each of the three studies I discussed. This shows the result of buying stocks after large sell-offs and volatility spikes.

As you can see, stocks generally bounce back strongly after these short-term market routs. Not always… but usually.

I wish I could say that it will get easier from here… or less volatile… or more certain. But those would be empty and unfulfillable promises. That’s just not how investing works.

For sure, heightened uncertainly over the Fed’s next move (or next speech)… over the U.S. presidential election… over any number of unforeseen “risk factors”… may continue to percolate through financial markets. But really, that’s par for the course.

My job is not to predict the market’s next move – up or down. My job is to stick to the systematic investment strategy that’s proven itself over time.

For now, the dominant trend in a majority of stocks is bullish… and so that’s where our bias remains.