Was it a computer glitch? Or was that instant evaporation of wealth for real?
The data feeds are clearly suspect. At one point, a small cap exchange traded fund appeared to have fallen 60% during the midst of the debacle. An hour or so later, the trading chart showed no such plunge. The data that people had, mid-day, seemed to have errors. When traders can’t “see” what’s really happening, bids dry up. That is an excellent way to foster a selling stampede. Smart money stepped to the sidelines until eventually bottom-fishers started buying in. The good news is that you can make an argument that if the market were to fall to around 9,875, then new buyers would likely step back in and provide “support.” They did today, anyway.
After buyers came back in, the market rebounded about 650 points to close at 10,520 on the Dow. The computer glitches and massive trading programs (sells, initially, and eventually buys) make today’s panic hard to interpret. Was it an anomaly? Or did it reflect the fact that “Greece” is the word?
One number that can be believed, today, is the VIX (the Volatility Index). We have been watching it creep up in the past few weeks to levels that used to signal panic. A couple of years back, the placid market resulted in VIX numbers in the low teens. In a more typical market, the VIX index is probably 18 to 20. In 2008, the VIX kept climbing to new highs and finally peaked somewhere over 80 amidst the worst crash in 70 years.
A couple of days ago, the VIX had snuck up to the 30 level amidst worrisome headlines in Europe. Today’s 1,000 point fall resulted in the VIX level climbing above 40, to a level never seen before – prior to 2008’s rout.
Today’s market is selling at fairly high levels, versus corporate earnings power and when compared to the March 2009 lows, but don’t let today’s high prices fool you. There is still a lot of fear left in this market. Today’s action proved it.
So what? Volatility in an up market is a good thing, right?
True, but more typically “volatility” is unleashed during a sell-off. Markets climb higher, bit by bit. But markets “plunge” down. If you know that volatility is high, it’s a much better bet that the market is selling off. That’s why the term “volatile” is now virtually synonymous with “falling.” Brokers will almost never admit that the market had a bad day. They can’t bring themselves to say that stocks went “lower” today. Instead, they just observe that stocks were “volatile.” They don’t fear that stocks are going to go lower. They’re afraid that “volatility” will continue.
With a VIX of 40, there is reason for caution. With a VIX of 40 and valuations that we believe are above normal, that is even more true. A high VIX and rock bottom prices may signal a fantastic buying opportunity. But a high VIX and high valuations suggest little upside, significant downside, and a ticking time bomb in your back pocket.
As you can tell, today’s activity doesn’t exactly call for a celebration. We continue to be cautious in our portfolio construction. Our mutual fund model fell -2.24% today, and the individual stock model portfolio fell -2.21% today, as compared to the S&P 500 decline of -3.24%. Eight out of ten fund holdings outperformed the market, though even gold and junk bond funds fell during the day. We have one position in “cash,” which outperforms everything else on a day like this, simply by standing still.
We are already positioned defensively. However, we could position ourselves even more defensively than this, especially if we once again feel the need to add a “bear market” fund that is designed to increase in value when the market declines.
If the market declines significantly, we could sell our high yield bonds and cash, and perhaps gold, to reinvest in stocks at much more attractive levels. However, if this market is to keep falling, we will likely try to position ourselves even more defensively on the way down.
Our Flexible Beta strategy tries to reduce risk in “volatile” markets. We have already taken a substantial amount of risk off of the table. That is why we captured only about 2/3 of today’s move lower. It might be possible to get even more defensive, however, and today’s spike in the VIX index would likely support such a move.
In general, today’s market activity supports our thesis that we’re at the high end of a trading range. We still believe that the economy has stabilized, still in recession. I have been more befuddled by the first quarter’s 5% surge in stock prices than I am by today’s fiasco. An overvalued market will find a reason to come down. It might be Greece. It might be that a computer glitch triggers program trading that causes things to get out of control. It might be that everyone knows that the market is overvalued but we’re in the midst of a melt-up as mutual fund investors spend down their cash in the face of a rising market. Eventually, however, something triggers the market to revert toward “fair value.”
Today’s panic is no reason for panic. On the other hand, for a thousand different reasons, I hope it doesn’t happen again tomorrow.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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