We've seen a meaningful drop in equity markets this past week, with a sizable pickup in volume and volatility. Not coincidentally, I have been fielding an unusually high level of phone calls and emails from concerned traders and investors. Because I am a psychologist who works with professional money managers and traders, it's only understandable that people reach out during periods of discomfort and uncertainty.
So what do you do if you're an investor in the stock market today? How do you navigate such volatility? In this article, I will share three pieces of perspective that might prove useful, whether you're a private investor or a professional money manager:
- Understand How Volatility Works - It's commonly recognized that volatility rises during market corrections and bear markets. Less well appreciated is the fact that this ramping up of volatility is not a linear function, but an exponential one. What does this mean? If you take a look at the chart I created above, you'll see a measure (red line) that I call "pure volatility". Pure volatility is the average amount of movement per unit of market volume. We know that volume and volatility are highly correlated: when there is more market participation, markets move more on average. Pure volatility takes volume out of the equation and looks instead at how much "juice" we get for each number of contracts or shares traded. During the period from early August to October 12th, the average five-day volume in the ES (S&P 500) futures went from a little over a million contracts traded to a little over 2.5 million. Volume in the corresponding SPY ETF zoomed from an average of a little more than 50 million shares to over 150 million shares. What pure volatility tells us is that the average movement per contract or share traded has doubled, even as volume has increased. As a result, we are seeing exponentially more movement than just a few months ago. This means that the level of profit and loss movement that you're experiencing now is probably far greater than anything you've seen in months. That volatility of your holdings can easily lead to greater emotional volatility--and poor, reactive decisions that have been shown to reduce average investment returns. Recognizing the potential for such reactivity is the first step in developing rational plans for navigating the changed environment. The best thing you can do, psychologically, at these times is not buy or sell but breathe. The faster the markets, the more deliberate you want to become.
- Understand The Larger Picture At Work Here - Back on September 24th, when stocks were near all-time highs, I published a blog post encouraging market participants to heed flashing yellow caution lights. Another measure that I follow closely, the cumulative number of NYSE stocks trading on upticks versus downticks, was in virtual freefall, suggesting that market participants were demonstrating more urgency in getting out of positions than in entering them. Similarly, a number of major sectors within the U.S. stock market, such as financials, energy, housing, and small cap shares, were staying stubbornly below their prior peaks. Of even greater concern, the post noted, international equity markets in Europe and especially in emerging markets, were in a meaningful downtrend from their January highs. What appeared to be a strong market when we only examined a chart of large cap U.S. shares actually looked like the last market standing from a global perspective. With concerns about tariffs, trade wars, and rate hikes on the horizon, not to mention uncertainty around the European Union (Italy, Brexit), it was reasonable to entertain the hypothesis that we were witnessing a cyclical peaking of global equities, with overseas weakness showing some contagion to the U.S. That measure of upticks versus downticks is even greater freefall at present and the number of stocks registering new 52-week lows has exploded higher. A prudent investor has to consider the possibility that there is a larger picture at work here that could lead to further correction and that might require near-term adjustments, such as portfolio hedges.
- Understand The Potential Reward At Work Here - In two recent blog posts (here and here), I took a look at similar large market declines over the past 10-20 years. Such historical analogs do not guarantee what future price paths will look like but do suggest possibilities. In both analyses, we find that bounces from the big selloffs are very common over the coming weeks. We also find that the volatility that has expanded exponentially continues high over the near term. In a majority of instances, we posted higher daily closes after the big drops--and we also posted lower ones. In other words, there has been considerable short term movement--and it has been in both directions. Moreover, some of the further declines have been sizable, as in 2008, 2011, 2015, and early 2018. Once again, this calls for caution and planning. That being said, many of these volatile periods have occurred near important market lows, also as in 2008, 2011, 2015, and 2018. When everything is downticking, it means that investors are bailing out of the great majority of shares--the good companies and the not-so-good. Recently we saw fewer than 5% of stocks in the S&P 500 universe trade above their 3, 5, 10, and 20-day moving averages! That kind of fearful selling often marks periods of longer-term value and opportunity.
So what is the takeaway for market participants? Imagine that you are taking a cross-country car trip and you run into a severe rain storm. The good news is that, once the storm lets up, people will be at home and fearful to go out and the roads will be clear of traffic. The bad news is that, while the storm is raging, you'll have to lower your speed and maybe even pull over to the side of the road. We are in a storm at present and those same factors that gave us yellow caution lights in September can also tell us when the weather is looking more favorable. The most important psychological takeaway is that the usual advice of trading coaches ("Stay disciplined and stick to your plans") can be worse than worthless. Markets have changed: direction has changed, correlations among stocks have changed, volatility has changed. Just as you would adapt your travel plans if you saw bad weather, it makes sense to revisit your trading and investment plans when the market climate shifts.
