"Volatility - Does it Spell Opportunity?"

Sydney M. Williams

Thought of the Day

“Volatility - Does it Spell Opportunity?”

August 23, 2011

“In the short run the market is a voting machine, but in the long run it is a weighing machine.” Those wise words of Benjamin Graham are worth recalling, as short term downward volatility has spooked investors into believing there is no long term. There are those who argue, at times like these persuasively, that the long term is nothing more than the culmination of a series of short term moves – why worry about tomorrow when today’s concerns are so paramount? Technical analysis often employs similar trends to determine future price moves. But the truth is that there is no magic elixir that unlocks the prospects for the future. Trends cease and tomorrow arrives.

The “voting machine” referred to by Professor Graham includes components of behavioral finance, money flows, sentiment, daily news bulletins, etc. This is the model used by traders and most quants, some of whom have been very successful, but more of whom have not. A “weighing machine,” on the other hand, assesses the present worth of a company based on discounted cash flows: it is an attempt to determine the intrinsic value of a company (an imperfect analysis, as it depends upon guesswork for future interest rates and company growth rates.) Patience and volatility then allow the investor to buy the stock below intrinsic value. Of course stocks can trade substantially below intrinsic value, but the concept is based on the expectation that everything eventually sells at its “true worth.” “Eventually,” however, is an indeterminate period of time. The point is that there are no easy answers. High frequency traders, in an attempt to quantify what is essentially a qualitative process, have recently proliferated. TV market commentators, each claiming to understand that which they do not, add to the din and confusion. In these unfriendly skies, the best chance most investors have is a sense of perspective, an understanding of history and the willingness and ability to determine a security’s intrinsic value.

The first fifteen trading days of August have equaled the combined volatility (in terms of the Dow Jones being up or down days more than 1.5%) of the first seven months of this year. On six of those days the market has been down more than 1.5% and on three days it has been up more than that level. The last time the market showed this much volatility was in the early months of 2009. March, the bottom of the market, had eleven such days. The record over the last few years was October 2008, when the market had eighteen such days (out of twenty-three trading days.)

For reasons I cannot explain, volatility has been more associated with market lows than tops. In the two months leading up to the market peak on October 9, 2007, there were five days in which the Dow Jones Averages traded up or down more than 1.5%. In contrast, in the two months prior to the market hitting its low on March 9, 2009, there were seventeen such days. In the two months leading up to today, there have been eleven such instances, nine of them in the last fourteen days.

As to whether recent volatility spells opportunity, or if it signifies nothing more than a duplicitous illusion designed to suck in unsuspecting investors, remains to be seen. But perspective is important. A debt-induced recession implies a recovery that must overcome deleveraging, ergo moderate GDP growth at best. So, increasing signs of slow economic growth should be no surprise. Leadership in the Western world, however, as it pertains to economic issues, is distinctly absent. The EU appears more muddled than us, unable to come to grips with what seems to the inevitability of an eventual disunion. It is unclear to me as to whether President Obama’s problem has been an inability to work with a, admittedly, diverse and opinionated Congress, or whether he lets ideology determine his actions. While I suspect the latter, whichever is correct, the affect is the same – an economically ineffectual Presidency. On both sides of the Atlantic there appears little confidence that the West is up to the internal challenges they face, or to the competition that will be coming from the East.

While the U.S. economy is trucking along at a rate barely able to absorb new labor entrants, emerging nations that had relied on the avid appetites of U.S. consumers must now deal with a slimmed down version. Their economies are continuing to expand, but at somewhat reduced rates, as lower exports cannot entirely be offset by increased domestic consumption and continued infrastructure spending. The market surely knows that the U.S. represents about 20 percent of global GDP, and that the consumer constitutes about 68 percent of U.S. GDP, or about 14 percent of global GDP. The American consumer’s retrenchment is significant.

Sharp movements in the market (volatility) provide commentators the opportunity to declaim that the risk trade is on, or it’s off. Their comments are always made in hindsight, so add very little value to investors. But that volatility does add nervousness into the mixture; thus we have seen notable flows out of equity and high yield mutual funds. The corollary is that we have seen inflows into money market funds, negligible yields in Treasury Bills and a Ten-Year Treasury that yields 71 basis points below the average of dividend paying S&P 500 stocks. Cash is plentiful. Banks have $1.6 trillion in excess reserves, and cash on corporate balance sheets represent the greatest percentage of assets in fifty years.

As Professor Graham would say, the market digests this information and “votes.” Investors are then able to benefit from another of his concepts – Mr. Market. Mr. Market, as the professor’s prize student, Warren Buffett has so often explained, is indifferent to exogenous or endogenous forces. He simply offers prices for securities. It is at the sole discretion of the investor, as to whether he or she wants to buy or sell. There is no time limit as to how long one has to wait to see the price one wants. Volatility suggests that among the pitches tossed there will be a few fat ones right over the plate.

Markets such as the one we have been experiencing provide anomalies – unusual instances of what seem to be remarkable mispricings. The most obvious case, in my opinion, is the yield on U.S. Treasuries. The Three-Month Bill currently pays one basis point. The Ten-Year yields 2.09%, not enough to offset current inflation trends. Of the 390 S&P 500 stocks that pay a dividend, the average is currently 2.8%. The yield on all the 500 stocks in that Index is 2.18%. As Birinyi Associates recently wrote, it is rare for the yield on the S&P 500 to be above that of the U.S. Treasury’s Ten-Year. Gold, another haven for investors who are fearful of economic conditions and policy responses, has risen 33% year to date to just under $1900. The value of the gold ETF, GLD, at $78 billion has now surpassed the SPY, the ETF for the S&P 500, raising the possibility that when gold prices do fall, selling by the ETF could accentuate any decline.

The annually compounded twenty-five year price return to the S&P 500 is 6.2%, not far off the very long term average. Markets such as the current one do provide opportunities for long term investors, those who prefer the market as a “weighing machine,” but they need to be ever mindful that the “voting machine” aspect of prices could take markets down further. If stock prices are up this morning solely on the basis that Fed Chairman Bernanke could offer QE 3 at Jackson Hole this week that, in my opinion, would be reason for concern.