Tag Archives: volatility

The Dangers of Low Volatility

On Monday, I discussed March retail sales and that its strength might be a positive sign economic growth. Today, there is more good news for the U.S. economy. According to the Wall Street Journal, “U.S. industrial production rose in March, moving beyond a lackluster winter and showing potential to gain strength in coming months”. Industrial production gauges the output of U.S. mines, manufacturers, electric and gas utilities. The manufacturing sector is only a fraction of domestic economic activity since the U.S. has transitioned to a service oriented economy. Nonetheless, many economists consider it to be an indicator of future demand.

In fact, economic activity across the United States is picking up steam. According to the Wall Street Journal, “Overall, the latest beige book, which describes economic conditions across the central bank’s 12 districts, pointed to an economy that was getting back on track after growth slowed earlier in the year”. This report, which is two weeks before the Fed’s April policy meeting, will likely have an impact on monetary policy. As the Fed continues to reduce asset purchases, the prospect of rising interest rates becomes more of a reality.

However, the Fed must watch the level of inflation when making its decision about interest rates. Even though economic activity is picking up, inflation is remaining stubbornly low and is a source of concern for the Fed. According to the Wall Street Journal,

Price gains could provide some comfort to Fed policy makers as they debate whether to keep pulling back on their easy-money policies meant to spur growth. Consumer inflation has run below the Fed’s 2% annual target for nearly two years, but price gains have accelerated a bit recently. Some central-bank officials have been concerned that low inflation—which discourages businesses and consumers from spending—could persist and weigh on growth.

Low levels of inflation are being experienced around the world. For example, the Bank of Japan is conducting asset purchases with the sole purpose of creating inflation. For this reason, the Fed can continue tapering at a slow pace as this should help push up inflation.

The problem with low inflation is it might be a symptom of something larger. We are starting to see the United States as well as other countries enter a stable path of growth. In addition, volatility is at very low levels. The last time we had a similar situation was during the Great Moderation. Starting in the mid-1980s, major economic variables such as gross domestic product (GDP) growth began to decline in volatility. In economics, the  “Great Moderation” refers to how stable the business cycle was at that time. We are again seeing that stable path of growth and global inflation, which is coinciding with an approaching of all-time lows again on volatility. However, this situation is easily disturbed. The first time around it masked a bubble in the housing market and that ended in a financial crisis. I am not sure what it is masking this time.

To Invest or Not to Invest…

Volatility has returned to the stock market. According to the Wall Street Journal, “The Dow Jones Industrial Average has swung up or down at least 100 points during the day on 25 out of the 26 trading days so far this year”. I believe the return of volatility is also a return of normalcy. I welcome it as it provides buying opportunities. During 2013, financial markets rallied virtually without interruption. Recently, markets have declined in what seems to be a correction. As I watch financial markets decline, I become excited about opportunities to purchase stocks cheap. Although I do not consider myself risk loving, I understand that risk and reward are intertwined.

However, not all people feel this way. According to the Wall Street Journal, “The financial industry has traditionally sorted investors into three types: conservative (willing to tolerate very little risk of loss), moderate (willing to take some risk) and aggressive (prepared to withstand high risk)”. For example, I think that conservative investors would certainly become frightened by  recent volatility. I find it hard to classify myself within these three categories. As a result, I prefer Benjamin Graham’s system in which investors are categorized as either enterprising or defensive. On the one hand, an enterprising investor is willing to spend time selecting securities that look more attractive than others. On the other hand, a defensive investor wants to avoid loss and does not want to make frequent decisions. Although the majority of the time I consider myself an enterprising investor, I become a defensive investor during school when I have less time to select securities.

Despite the weak performance in financial markets so far this year, stocks are still not cheap. According to the Wall Street Journal, “At the end of last year, U.S. equities were trading at 25 times their average earnings over the past decade, adjusted for inflation. At the recent low on Feb. 3, that was down to 24.2 – still far above the long-term average of 16.5, according to data from Yale University economist Robert Shiller”. On the basis of price to average earnings over the past decade, stocks continue to be expensive. I think this is a much more useful financial metric than forward price to earnings, which uses projected earnings that I find completely unreliable.

As an enterprising investor (at this moment I do have time to devote to security analysis), I hope that stocks continue to fall because this will provide more securities at bargain prices. According to the Wall Street Journal, “If you are an enterprising investor, then you should monitor the financial markets carefully in the hope that a substantial fall will present bargains”. This continues to be my attitude. Although I hope stocks continue to fall, cheap securities can still be found in the current market of mildly overpriced stocks (you just need to look hard!). As a result, some might call our current situation a stock pickers’ market. Whereas last year, a rising tide lifted all boats and one could have just invested in a stock market index.

I really value the integrity of financial markets, however, I become discouraged when I read about certain investors having a competitive advantage. According to the Wall Street Journal, “By paying for direct feeds from the distributors and using high-speed algorithms to crunch data and enter orders, traders can get a fleeting – but lucrative – edge over other investors… The reason: tiny lags between the time the distributors release the news and when media outlets send them out to the public, including other investors”. Although this direct access is not illegal, it destroys what is supposed to be an efficient market. The efficient market hypothesis suggests that financial markets reflect all publicly available information, however, for a few milliseconds traders paying for direct access have information that others do not. As someone investing for long-term gains, high-speed traders with direct access to news releases do not significantly impact my strategy. Nonetheless, I am surprised that this is type of activity is legal as it reminds me of insider trading.

Financial regulation seems to be way behind the curve. According to the Wall Street Journal, “The Securities and Exchange Commission’s fair-disclosure rule, Regulation FD, requires that public companies issue material information about their businesses to the broader public at the same time it is disclosed to market professionals… The rule, written before the era of high-speed trading, doesn’t address whether fractions of a second matter in terms of when information is distributed”. Based on this interpretation, it seems that the SEC intends for this type of trading to be illegal (obviously I am just speculating since it is hard to accurately determine the intentions of the SEC or any organization). I am curious about potential future regulation.