Volatility Kills

High volatility kills investors – certainly financially, and occasionally literally. Unhinged by large down moves and demoralized by the quick evaporation of the occasional big “relief rally” day, investors become irrational. They stay up at night plotting strategies which they completely reverse the next day. They obsessively follow every twitch of the market and castigate those who told them to “Stay the course.” Then, with their financial and personal life in tatters, they sell out at the bottom (of course no one knows it’s the bottom at the time).

Hence the gallows-humor adage – “vol kills.” But what about the opposite – when vol is low? The past fourteen months or so (until 1/29/18) have witnessed one of the least-volatile major rallies in stock market history. Whether measured by the relative absence of big up and big down days, or measured as an average volatility of each day, it had been extremely quiet. Now vol has spiked to 49 (as of 2/6/18). Should you sell because “vol kills”?

There are always some practitioners who will say yes. “Following” vol to make decisions is similar to “the trend is your friend” technical analysis. It assumes that the framing of the question – what time interval is the correct one to use? – has been done “correctly”. The technical analyst chooses what moving average to use, or what sets of moving averages. Thus vol is either incredibly high using just the past few days) or still moderate (using an average of the last year or so). So you could either sell because you fear that it’s rising, long-term, or buy into the current panic, hoping that the currently high vol will settle down.

You have seen the simpleminded clickbait titles all through this rally such as “This billionaire is predicting the market will fall 90%, and he has taken all his money out of the market.” The trouble with these dumb anecdotal pieces of “evidence” is similar to the problem all bears face today – when or whether to admit you are wrong. For example, if a more reasonable bear had said early last year (when the market was about to rise over 30% in the next twelve months) that he expected a 15% correction in the stock market, and if he has never changed his stance, he may eventually finally get his predicted 15% correction – we’re more than halfway there in just a week! The sticking point is that even if it happens to get to a 15% drop off the high, it would still leave the market above the level it was when he first made his bearish forecast. So you if you had followed his advice back then, you would still have lost money, even if the 15% correction does occur.

Just as “economic expansions don’t die of old age” (meaning there has to be a reason for a recession beyond the mere fact that there hasn’t been one in a long time), it’s also true that volatility doesn’t spike upward merely because it’s been a while since it last did that. In my opinion it still pays to analyze the fundamental reason for volatility spikes to see if you can decide whether they are short-run phenomena or symptoms of a larger sea change in the economy and/or corporate profits.

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