The extreme stock market volatility of recent months has been difficult for long-term investors. It would be a mistake, however, to overreact. Volatility in itself does not mean a downtrend in the market. The volatility will ease, and can even provide investment opportunities.
The most widely watched measure of stock market volatility is the VIX index.
It is commonly called "the fear index" but actually is a mathematical calculation of expected changes in the S&P 500 index over the next 30 days. The equation is based on the call and put option premiums for S&P 500 contracts, measuring the price traders are willing to pay for the opportunity to benefit from a potential swing in the market in either direction.
Although call options premiums are in the calculation just as much as put premiums, it is the puts that drive the index. This is because traders are more willing to pay high prices to bet on a quick plunge in the stock market than they are on a sharp spike upward.
The VIX thus tends to rise when fears of a market downturn increase, which typically happens after a market decline.
Below is a chart of the VIX over the past two years.
The first spike in the VIX index on the chart reflects a large drop in the stock market last summer. The VIX spiked well over 30 on concerns that financial turmoil in Europe would cause additional declines in the U.S. stock market.
The chart also shows the VIX index rising sharply in August of this year as the stock market plunged again this summer on similar fears of contagion from the ongoing European debt drama.
The VIX then declined last fall and winter as the stock market rallied, and traders were no longer willing to pay huge premiums for put options. The risks and fears ebbed.
In times of extreme market volatility, there are plenty of pundits ready to suggest that investors protect positions with options -- typically purchasing put options against long-term positions. Just turn on the TV a day after a sharp market decline, and you'll frequently hear that advice.
This, in your author's opinion, is almost always poor strategy.
Whenever market volatility increases after a sharp decline in the market, the "fear index" will spike. But that is a backward-looking consideration.
The index has spiked because the option premiums on puts have already risen dramatically. This is after the market has already fallen. To buy protective puts at that time will involve exorbitant costs. They will prove worthwhile only if the market (or individual stock against which the put was purchased) plunges even further -- much further.
Whenever an investor buys a put or a call option, the position doesn't pay just because the direction of the market is accurately predicted, but only if the market moves substantially in that direction. It usually doesn't work.
Volatility also must not be confused with bear market fundamentals.
Granted, bear markets are associated with high levels of volatility and a high VIX reading. Nevertheless, a high level of volatility in itself does not mean a bear market, and doesn't have to mean a declining portfolio value.
There have been countless articles about how investors should deal with the recent high level of market volatility. There was a point this past summer when there was considerable talk about a "bear market" because the S&P had fallen approximately 20% from its recent highs and how investors should adapt to the changing environment.
In fact, the best advice was simply: stick to your long-term investment plan.
Here are the facts on the change in the S&P 500 from recent years based on the Friday, November 4, 2011, close of 1253.23:
Change from one-year ago: +2.6%
Change from two-years ago: +19.8%
Change from three-years ago: +24.6%
The best strategy has been to take positions and to hold them, even through the gut-wrenching ups and downs.
The important issue in investing is to develop a strategy based on long-term fundamentals and to stick with that strategy.
To react to every headline out of Europe, or every (publicity-seeking) pronouncement that the U.S. economy has entered a double-dip recession because of a couple of bad economic numbers, will not only drive an investor crazy, but will also probably lead to some very poor decisions.
The current long-term fundamentals are reasonably good.
Most importantly, stocks hold significant relative value (Please see our February 28, 2011 article). The earnings yield on the S&P 500 index is 5.59%, based on almost complete third quarter earnings data.
Earnings growth in the third quarter was 17%. Earnings growth is expected to be 11% in 2012.
The U.S. economy continues to slog along with decent but subpar growth. Real GDP should rise 2% to 3% in 2012.
And the alternative to the S&P dividend yield of 2.00% with rising dividends is a locked-in meager 2.03% on a 10-year government note. Stocks have excellent relative value.
There is always risk in owning stocks. Stock prices can certainly go down. Yet, there is a great deal of variability in risk within the stock market.
This column in recent years advocated for investments in high-quality, high-dividend yield, multinational companies. Many of these stocks are actually low risk.
A list of such stocks might include 3M, Abbot Labs, Coca-Cola, Exxon, Johnson & Johnson, McDonald's, Procter & Gamble, and Wal-Mart (as discussed in our September 12 Big Picture column).
A number of these stocks actually sport credit ratings of AAA, higher than the U.S. government. Most provide a greater yield than the 10-year Treasury note. All have rising profits, and all have increased their dividend every year for 29 to 53 years.
Many of these companies have exposure to Europe and earnings growth will undoubtedly be constrained for years by what could be a stagnant European economy. That is well recognized, however, and a great deal of the risk is already priced in the stocks.
Perhaps most relevant for those concerned with volatility, these stocks are also far more stable than the market in general. Every one of these stocks will get caught in a downdraft affecting the overall market, but far less so than most other stocks. And, when Johnson & Johnson gets pulled down by overall volatility, it often simply represents another excellent entry point for long-term investors.
The recent market turmoil doesn't have to disrupt your life or your portfolio.
It is advisable to keep on top of the developments out of Europe, but also to understand the implications. Most important right now might be that Europe is actually addressing its problems. They won't be solved right away and Europe certainly has a long slog ahead. But at least issues such as pensions are being discussed in a manner which the U.S. hasn't even approached.
Take a longer-term view for your longer-term investments. Turn off the TV. Keep the 4% market swing on the latest rumor out of Europe in context. Stay with that portion of your portfolio in high-quality stocks.
And keep cashing those dividend checks.--Dick Green, Founder and Chairman