The typical investor tends to underestimate volatility, though it may be a generation before they make that mistake again given the recent 100-year flood of volatility we’ve just experienced.
“Standard deviation” is one measure of volatility. Over the long haul, the typical standard deviation for the market is almost 20%. That is the percentage by which the market will “typically” (19 times out of 20) deviate from the normal return. Many people hear a 20% standard deviation and, given a “normal” return to stocks of 10%, form a mental picture of the market swinging from 0% to 20% during most years. This underestimates normal stock market volatility. Forbes columnist, Ken Fisher, wrote a fantistic piece explaining how most people underestimate volatility, but unfortunately I didn't save it and I haven't been able to Google it to provide a link.
During some periods, like what we just experienced, the market may swing from 20% overvalued to 20% undervalued, for a top-to-bottom 40% swing. This is normal for the market, probably once every 20 years.
One reason to take this crash all in stride is because that’s just what markets do. They crash, and they soar, and when volatility is high sometimes the plusses and minuses balance each other out and you get a market like the one this week where the market moves more in a day than it typically moves over the course of a year, but with no significant move overall. The key to understanding volatility is to try to make the best of it. It is almost always the case that the worst thing you can do is let downside volatility frighten you out of the market.
Don’t get me wrong. We’re not in a “normal” market. We just experienced the worst crash in 100 years of U.S. stock market history. However, some context is important. And, to some degree, this is just what markets do.
Almost exactly a year, the Dow Jones Industrial Average peaked at 14,169. Assuming that it was 20% overvalued on that day, it would put “intrinsic value” for the Index, last October, at about 11,800. A year later, Bear Stearns and Lehman Brothers have disappeared from the scene and the market (hopefully) “bottomed” on October 10th at just below 7,900. Assuming that it was 20% undervalued on that day, “intrinsic value” for the market would be about 9,875.
Intrinsic value isn’t supposed to move around much. Intrinsic value is supposed to be fixed, while stock prices move around. Could intrinsic value possibly have fallen 17% from 11,800 to 9,875 in only a year? In my view, given the severity of the financial crises, the interventions required to halt the panic, and the long-lived repurcussions we will feel, the answer is yes.
In my opinion, it’s not the sub-prime mortgage mess that brought the economy to its knees, but rather the myriad of derivatives contracts and credit default swaps that acted as an accelerant and caused the fire to sweep quickly through to all banks and insurance companies, and which eventually caused the bond market generally to cease to function. When good companies couldn’t refinance their debt because no one knew how much counter-party risk anyone else has, our economic system ceased to function.
When the show trials begin, my hope is that it is these Wall Street casino operators who originated hundreds of trillions of dollars of investor-to-investor wagers who will be doing the perp walk. It is these “financial engineers” who made their fortunes building the current disaster. They collected their cut up front and have left the U.S. taxpayer on the hook for bailing out the system that they came all too close to destroying.
We are just now beginning to see some functions restored. IBM issued bonds last week. They were the first company to be able to do so since September 2nd. There were a couple of other new issues priced and sold, this week. The bond markets are starting to function again. We’re beginning to see banks re-extend lines of credit to some borrowers. The European banks have reduced, ever so slightly, the premium they’ve been charging to risk making loans to their American counterparts. We’re starting to see signs of life. There is still a lot of recovery that needs to happen.
The damage hasn’t been limited to the United States, of course. Foreign markets have plunged as well. To me, the falling value of oil prices has been a proxy for fears that the world economy will sink into the abyss. I think there are other things going on as well. Thanks to the casino operators, investors no longer trust paper assets. Ultimately, gold futures are paper assets. I think that commodity prices are depressed partly because investors are unwilling to speculate in derivates until we know which counterparties are going to survive to expiration day. I am reading that in some physical delivery markets, prices take place at a premium to the “spot market” (futures) price, and that vendors are far behind in being able to make physical delivery (i.e. there are shortages). The real economy maybe isn’t in as bad a shape as the futures markets are telling us. Maybe, what’s in really bad shape, is merely the futures markets themselves.
We continue to have money on the sidelines, available to invest in the market at much lower levels than a year ago. Ultimately, getting back some of what has been lost requires a willingness to invest. I have been willing to wait for some signs that things are getting better before being willing to commit capital to this market. I am relieved to see signs that things are turning up. By the time it is clear beyond a shadow of doubt, it will be too late.
If “intrinsic value” truly lies around 9,875 (for the sake of argument), the market could easily rally to the 10,000 to 11,000 level and stay well within its traditional volatility range of +/- 20%. We won’t be able to take advantage of this volatility if we’re still on the sidelines. The pressure, at this point, points toward getting back into the market so that we can take advantage of upside volatility before it’s too late.
Liquidity is returning to the market. Oil prices are stabilizing, suggesting hope for the global economy. Third quarter earnings, outside of the financial sector, haven’t been too bad. Patience paid off this week. However, I probably don’t have a lot longer before the plusses outweigh the minuses and this market takes off to the upside.
The economic statistics will get worse before they get better. The stock market, though, may have already factored in the “worst case” scenario. Hopefully we will start seeing volatility work in our favor. It may not signal a new bull market, but some recovery would be nice and it seems like we’re about due.
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