The Striking Price

The Stock Market's Awful Sense of Timing

STEVEN M. SEARS

Saturday, October 18, 2014

Accurately predicting volatility would greatly help investors, but it's almost impossible to do.

Before predatory computers determined and distorted liquidity, floor traders liked to say that he who changes his volatility first, wins.

To me, the old saw always meant that the market is right on price, but has a horrible sense of timing. If you knew how volatility–and thus the underlying market–would evolve, you'd be well-positioned for whatever came next.

In the past two weeks, the stock market has experienced extraordinary moves. The S&P 500 sharply declined. The stock market's fear gauge, the CBOE Volatility Index (VIX), which was around 11 in August, is now near 22–up about 100%. Thursday, as traders paused to assess the extraordinary price volatility, it was oft-noted that the VIX had stunningly jumped 73% in just a week.

We take some solace in having advised investors to hedge their stock portfolios before the decline, but that was easy. The hard part is calling the next move. Clarity is now the world's most elusive asset as the market mob is obsessed with the shadows cast by economic data.

IT WAS EASY recommending buying volatility via equity and ETF options when the VIX was low and stock prices were high. Selling high-priced puts to buy blue-chip shares that pay dividends always makes sense for long-term investors. But investor sentiment–what Keynes called animal spirits–is now extremely unpredictable amid the U.S. dollar's strength and the fear of a global economic slowdown.

Wal-Mart (WMT), the world's largest retailer, is warning of tough times. It lowered its sales growth forecast in the current fiscal year to 2% to 3%, down from 3% to 5%. Why? Lower food-stamp payments and a stronger dollar.

In the options market, which is usually prescient about the stock market's next move, defensive confusion seems to reign supreme. My trusted voice sentiment indicator–speaking with top traders and strategists to gauge stress levels during big market and volatility moves–reveals neither panic nor confidence about what's next. This tends to indicate that volatile markets are ahead. Everyone can feel good that stocks rallied sharply Friday, but it was really just another sign of volatility.

IT IS OCTOBER, OF COURSE, the month that historically humbles Wall Street. Yet, more than seasonality is at play. Greed turns to fear in the fourth quarter because Wall Street will soon pay bonuses, and no one wants to diminish his. Many investors destroyed their year over the past few weeks. When this happens, trading patterns can be increasingly erratic as traders labor under great pressure to protect income for themselves and their families.

To be sure, everyone on the Street seems to have a copy of the 80-year volatility chart that supposedly shows what happens around various events. Everyone is armed with a theory and model about what might occur as the Fed prepares to exit the bond-buying scene. The past few weeks, however, prove Mike Tyson's rule of investing: Everyone has a plan until he gets punched in the mouth.

Based on the recent volatility, it's hard to believe anyone has a good idea of what will happen next. The VIX's rapid ascent must be taken as a sign that the end of quantitative easing, and the inevitable rise in rates, will be accompanied by extraordinary volatility. Should the VIX decline, and hedging costs return to more reasonable prices, protect your portfolio.

Investors seem to have abandoned the old playbook of trading events and earnings and riding hot stocks. Macro-market issues now dominate trading in ways unseen since the 2008 credit crisis. Every bank, and all investors, seem to have a different view on what's next. Amid the clash of opinion, remember: Mean reversion is a beast if you are on the wrong side, so use volatile volatility to your advantage.

Reprinted by permission of Barron's Online, © 2014 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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