Living With Higher Volatility

Submitted by David Gratke on Wednesday, October 29, 2014 - 9:00am
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Volatility, on vacation for most of the past few years, is back this fall. It hit a new 52-week high in mid-October, double the level of August. That means change is afoot in the market, whose rally lulled many into complacency. So this is a good time to see where your portfolio stands in risk terms.

The last time volatility really spiked, as measured by the Standard & Poor’s 500 volatility index, or VIX, was the fall of 2011 when the market last corrected by 20%. Then, the VIX level was twice as high as now. Volatility is market price fluctuation, and it signals greater risk.

The root cause of higher volatility is that the world’s major central banks, including our Federal Reserve, have flooded markets with liquidity – printing money, if you will. In other words, in an effort to jump-start local economies, they have kept rates so low that stocks are artificially higher, and thus ripe for a price-churning correction. The insidious side-effect of this money printing has been to greatly reduce, if not extinguish, historical, and normal, market price fluctuations.

As David Kotok, chairman and chief investment officer of Cumberland Advisors, puts it: “An era is ending: for over half a decade, nearly worldwide, zero interest rates suppressed volatilities. That is over.” The initial indication of this, Kotok says, was when then Fed-Chairman Ben Bernanke indicated that his bond-buying stimulus program was coming to an end. Well, now it’s over and the market fears interest rates are on the way up.

Stock market volatility can be measured and is used to gauge investor thinking, or what we call investor sentiment.

The VIX gauges investor sentiment. When volatility is low, the implication is that investors are complacent. Said differently, they are not paying attention to the underlying risks in the marketplace. Also during times of low volatility, markets are often fully valued, or even overvalued due to investor contentment.

When the VIX is high, as it was during the 2008-09 financial crisis, investors exhibited great amounts of fear. They sell out of their investments, and markets are typically undervalued.

Volatility was low prior to 2008, hovering around its historical average of 20. The index then zoomed to 90 during the 2008-09 stock market slide. In recent months, however, most notably June and July, we witnessed a historic low in this index, hovering near 10. Sure enough, there were high levels of margin balances and bullish investor sentiments, along with above-average stock valuations, as seen by lofty price/earnings ratios.

Now, the VIX is slightly below average, at about 15.

Since August, volatility rose from its sleepy historic mid-summer lows for many reasons: Middle East tensions, the Ebola outbreak, low gross domestic product growth, central bank stimulus slowing down, corporate stock buybacks, high P/E ratios, just to highlight a few.

Assuming this higher volatility is the new normal, what can you do about it? One alternative is to do nothing and ride this out. Another is to trade options, betting on which way the market will cut. But this is very risky and best done by professionals. Kotok says a volatility surge is a good time to examine your portfolio’s risk profile: His firm’s largest positions are in defensive stocks, like utilities and telecoms – ones that don’t tend to rocket around when the market gyrates.

During a recent volatility boost to the current level, in 2013, a Wall Street Journal story offered some market pros’ tips. Examples: putting money in a balanced fund, where stocks and bonds are in roughly equal proportion. Another warned that whenever stock holdings were over 70% of a portfolio, or under 30%, you are most vulnerable.

Regardless, Kotok cautions that “more and exciting volatilities lie ahead.”

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David Gratke is chief executive officer of Gratke Wealth LLC in Beaverton, Ore.
 
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