Saturday, January 31, 2009

The Myth of Volatility

Common financial "Wisdom" states that the US stock market produces superior returns compared to other assets such as Bonds, Cash and other savings vehicles, even commodities. These returns are obviously necessary in order to get ahead of inflation and prepare for a period of retirement in relative comfort and enjoyment. There are certainly periods where this is true; however there are also periods of significant downturns, which represent the associated risk for achieving these superior returns. The theoretical "Best Practice" in dealing with these periods of uncertainty is to "Buy and Hold" for the long term, however many investors struggle with this strategy. In practice, while the Stock Market is more volatile than other asset classes, it ultimately tracks to the overall economic fundamentals and dramatic moves in one direction are met with dramatic moves in the opposite direction. Longer term economic trends can span periods measured in generations, resulting in the need for a more sophisticated investment perspective beyond a simple "Buy and Hold" strategy, or as I like to call it "Buy and Pray." This article will get into why you might want to think twice before assuming the Stock Market makes a stellar return over the next couple years.

The dramatic moves, referred to as volatility, are what draw many of us into participating in the stock market, tapping into basic psychological desires of excitement, euphoria and ultimately the logjam of fear. The way these emotional draws generally play out however, are the wrong decisions are made at the worst possible moments, leaving the retail investor significantly behind potential returns because basic human psychology runs counter to making the right moves in the market. The reality is that very few investors catch even one side of the market extremes and very few trades actually take place at those dramatic points on the charts.

There is a huge industry with many interests touting mythical returns, and a lengthy line of consumers following along. There are currently more mutual funds than tradable stocks, each collecting management fees out of the assets they've locked up. There is a never ending supply of software providers, trading systems, books, classes, seminars and other get rich schemes ready to hand over the keys to the American dream of endless riches for a small price. Financial vehicles have become so sophisticated that few professionals truly understand how the various financial markets operate and interact with one another. For the last several years, the financial services industry has been the largest sector of the economy and I still can't get my head around understanding what relative constructive value this industry provides to the progress of humankind, although it's been a hell of a ride for trading opportunities.

The main bellwether I look at to gauge the stock market is the S&P 500 index (ticker SPX). This is a composite of the 500 largest US Stocks, which is a pretty wide range of companies. I prefer this vehicle to the Dow Jones industrial average, which is a more subjective index of only 30 stocks and the individual exchange indices, which are more sector sensitive. The SPX is also the most heavily traded financial asset and is generally used as the performance baseline for mutual funds and other investment vehicles. Here's a monthly chart of the S&P500 starting in 1999. To the left of the chart is a stunning bull market winding its way back to the early '80s.

In technical analysis terms, this is about as beautiful a "Double Top" as one could find. The top yellow line represents the high achieved during the Dot-Com boom. Towards the tail end of 2007, this high was tested and the market failed to sustain that level. Likewise, the lower level represents the low made in 2002. In late 2008, this low was tested and the market bounced off of that level as a support. The important thing to note with technical analysis is that markets often react to recognizable price patterns; in large part because so many traders are watching the same patterns that it becomes a self fulfilling prophecy. Currently, the SPX is nominally above the 750 support level and the technical perspective would be that if that support level is broken, the next one will be tested. Unfortunately, there isn't a clear next level of support. But there is more to the story….

In the following chart I plotted the annual US Gross Domestic Product (GDP) and the S&P 500 dating back to 1950.

This time the SPX has been smoothed for inflation by adjusting against the Consumer Price Index (CPI), as was done with GDP. GDP makes a slow and progressive ascent up the chart, which is representative of a long term growing and stable US economy. Over that time, the stock market has its Bull and Bear periods, with the high being the pinnacle of the DotCom boom. Notice how the more recent bull market fell short of the highs of 2000 when using inflation adjustment? This is an indication that we've been in a relative corrective period for the last eight years. The other interesting thing to note on this chart is the black line, which is an exponential regression of the S&P 500 over this period. Note how closely it follows GDP over the long haul while the Bull and Bear periods fluctuate across the chart? That comparison is an indication that the stock market stretches between extremes, but eventually finds equilibrium, which in statistical terms is a reversion to the mean (against GDP). This is what volatility is all about.

When the market performance is adjusted for inflation, the high achieved in 2007 and the low tested in 2008 are substantially lower in real-dollar terms compared to the levels of the 2000 market cycle. In fact, you need to look back to 1995 to find levels that equate to today's ranges. That's a sobering thought for me considering that was only a brief time after I had started investing for my retirement. In the next chart, I'm plotting the same data; however I've normalized GDP to be a constant in order to evaluate the relative valuation of the stock market against GDP:

This is where things get really interesting. What are illustrated here are the longer term valuation cycles of the market relative to the overall economy. There are certainly intermediate trends, which are visible in the choppiness from year to year. For example, the period between 2003 and 2006 represented a recovery period after the bear market of 2001 – 2002, but it was in the context of a larger correction cycle. The big picture is that the market pricing structure relative to GDP has very long trends. Comparing the current cycle to the last major cycle, there is a potential for several more years of undervalued stock prices.

The other conclusion that one could make would be that there is still room for additional correction and comparing the current value to the point where the turnaround occurred in 1982, the SPX could easily move down to 600. That's a pretty scary number. The last time the market was at that inflation adjusted level was in 1991, which was when I graduated from college. Of course you can also find that level in 1987, which was when I graduated from High School, and the period between 1965 and 1969, which was when I was born. Are you doubting the buy and hold strategy yet?

As a point of interest, let's take a look at the first chart again, this time adding in one additional investment strategy, which is of course beautiful because it happened to someone else (maybe) in the past. I usually hate it when analysts do this kind of curve-fitting analysis, but it's my article and I can add what I want. Looking back at 1982, which was the bottom of the most recent long term valuation cycle, 30 Year Treasury Bonds were paying out between 13 & 14%. The blue diamonds represent the non-compounded returns of a bond investment over that period. The market value on those bonds would also be substantially higher today than their original cost, which is not reflected in the chart, but makes the strategy even better. Also keep in mind that the stock market was about to take off into its greatest bull period of our lifetime, which had returns during certain periods significantly higher than 14%.

If you had been insightful enough and able enough to invest in bonds at that time, compare where you would be compared to the stock market today (isn't that an alluring statement). Your returns would be 50% higher and you wouldn't have gone through the bloodbath losses during the crashes of 87, 2000 and 2008. Of course you would have had to ignore some amazing bull stock markets and spent a good chunk of that time underperforming what peers might have been able to return during these periods – I don't know many people that can do that. I'm also not suggesting you go out and buy bonds at this point. As a matter of fact, I suspect bonds are one of the best shorting opportunities in years. The point with this last exercise is to illustrate that the markets provide occasional opportunities for outperformance, but these opportunities aren't around all of the time. From my perspective, "Patience and Preparedness" are more effective tools to approach the market than "Buy and Hold."

The good news in looking at all of this information is that throughout all of this market volatility, GDP has remained relatively stable and the prospects for a recovery in the broader economy are somewhat inevitable. Although there will likely be painful adjustments, the US economy will be fine over the long term. At some point there will be another incredible bull market in stocks, but I'm not optimistic about that happening in the next few years, but more on that at another time.


  1. I remember the high bonds and cd's during the 80's. I also remember how mad our parents and their friends got when the bond issuers PAID the the bonds off early. It was there option to pay them off, so they could then borrow money at a cheaper rate. CD's of course were not paid, but you can't get them very long term. Bonds are part of the balanced portfolio, and low risk. But low interest bearing bonds certainly won't sell at a premium, if you decide to sell them before maturity.

  2. by the way, nice job! nice insight on how so many businesses make money off the business of know what i mean. or, i mean i got your meaning. meaning....yeh.... ;o)

  3. Yeah, in one of my next posts I'm going to really tear into wall street and get into how the shift to self directed retirement planning was mainly a boon for investment banks and not so much a help for folks like us.

  4. Ok, I have a blog too- Herein lies the difference between us (and there are few, in my opinion). Nice work, John. You're my hero.