Warning: the lifeguard’s not on duty. Swim at your own risk.
That’s the way investment advisor Richard Bregman views today’s market. “If you go into the water, there might be riptides, sharks,” says the CEO of MJB Asset Management, a New York-based firm that manages a little over $100 million in assets. “I want to be hedging for the out-of-the-blue moment.”
Like September 11 in 2001. Or the near-crash of the United States’ financial services industry in 2008. Or perhaps the total collapse of the euro zone in 2011 or 2012.
Anyone with eyes and ears knows that these once-in-a-lifetime events seem to be happening with greater frequency these days. Things that aren’t supposed to happen are indeed happening, and the stock
market has whipsawed as a result. The crash of 2008 and 2009 led to the gold rush of 2010. Which in turn led to the peaks and valleys of 2011.
What will 2012 bring? Volatility seems a near-certainty. In fact, the market is more volatile today than it has been at any time over the last five decades. An advisor’s job today is not just “buy and hold” (or “buy and hope,” as Bregman likes to say) but to take an active role in managing his clients’ money. When dealing with volatility, that means widening the investment horizon with strategies that include managed futures funds and arbitrage, as well as commodity trend indexes and stakes in currencies and real estate.
The aim, says Bregman, is to embrace diversified strategies, not just diversified portfolios.
“If the goal of an advisor is to keep clients from making suboptimal decisions, then you want to take volatility out of the marketplace,” Bregman counsels. “If they don’t panic, you have a much better chance of adhering to your investment strategy.”
Just how volatile is today’s market? According to an analysis performed by the New York Times in October, the market is more volatile today than at any time since 1962. In today’s market, it is six times more likely for the price of stocks to fluctuate 4 percent or more during intraday trading sessions than it was in the four decades leading up to 2000. Looking at closing prices alone, the Times found that since 2010, some 30 percent of trading days were up or down more than 1 percent by the time the closing bell rang. That compares to 20 percent of such days in the 1990s. Andrew Lo, a professor of finance at the MIT Sloan School of Management, discovered that 10 of the biggest 20 daily surges and 11 of the largest 20 daily dives from 1980 to September 2011 have occurred in the last three years.
The VIX, the market volatility index established by the Chicago Board of Trade in 2003, stood at 27.80 at the beginning of December, above its historic average of around 20, but far below its peak of nearly 60 in October 2008.
The causes of this volatility are both apparent and hidden. The U.S. economy is still recovering from the shock of 2008. Electoral uncertainty and the fate of expiring tax cuts have also left investors guessing. Unemployment remains high and corporate leaders are having trouble gauging the price-conscious consumer. Worst of all, the world’s second largest trading block, the euro zone, is on the edge of collapse. While some argue it is too big to fail, others see unsustainable spending and unwillingness among political leaders to take the steps necessary to right Europe’s course.
And then there are the hidden factors. Nadia Papagiannis, director of alternative fund research at Morningstar in Chicago, points to high-volume traders as the source of much of today’s stock market volatility. In a late 2010 article appearing in Morningstar’s Alternative Investments Observer newsletter, Papagiannis noted that high-frequency traders, who use automated trading programs to trade in and out of securities in a nanosecond, now represent 60 percent of total U.S. stock-trading volume. One study pegged the profits of high-frequency traders at $21 billion to $25 billion in 2008. While some argue that the liquidity they provide can only help the markets, Papagiannis is not convinced. She points to “less-than-legitimate practices” among some of the traders that have caused average investors to lose their shirts.
“One such practice relates to trading ahead or front-running institutional investors for liquidity rebates provided by exchanges. Yet another involves ‘latency arbitrage,’ the ability of certain market participants to profit from the relatively slow quotation system informing the rest of the market,” Papagiannis writes. “Although the evidence of these practices is hard to ignore, the total impact on investors is difficult to quantify. Nevertheless, public confidence in the equity markets is eroding, and the SEC and industry participants should attempt to stamp out these manipulative practices before the damage is irreversible.”
How to Deal With Volatility
For financial advisors, volatility is a headache. Not only do gyrating stock prices make it difficult to chart a future course, clients also react emotionally to market movements, forcing the advisor to play counselor as well as money manager.
According to Less Antman, founder of Simply Rich, a financial planning and asset management firm in California, volatility is always a reflection of uncertainty about the future. These days, the factors that contribute to uncertainty are many: the new strictures of the Dodd-Frank Wall Street Reform and Consumer Protection Act; the uncertain effects of Obamacare; talk of yet another stimulus program. All these have advisors and investors alike tied up in knots waiting for a resolution.
However, much as one may be tempted to do so, Antman suggests advisors steer clear of attempting to profit from market volatility. “It is not a game worth playing,” Antman said. “Job one for an ethical advisor is teaching his clients the importance of patience and discipline in investing. Any attempt to play short-term moves in the market undermines that goal.”
The best long-term strategy for dealing with volatility, Antman said, is to embrace it and recognize it as the source for the long-term return on equities we’ve all come to expect. “Volatility is only an issue for clients with near-term spending needs or serious emotional difficulties handling the inevitable periodic market declines,” Antman explains.
While a diversified portfolio is a given, in these turbulent times Antman is also keen on commodity trend indexes, which have a strong negative correlation to the markets. As hedges for investors seeking protection against major bear markets and concerned about intermediate-term equity volatility, Antman likes the Direxion Commodity Trends Strategy Fund (DXCTX) and the WisdomTree Diversified Trends Index ETF (WDTI).
Bob Southard, a 43-year veteran of the investment industry, isn’t all that concerned about market volatility. To his mind, volatility has simply crept back to where it was following the relative market calm of the 1990s. But what does concern Southard, a principal at Greenrock Research and a co-founder of the company known today as PIMCO Advisors, are world-changing events that may unfold in the weeks and months to come.
The first and most significant of those is the European debt crisis. “What we have right now is what I tend to believe is an insolvable financing problem for the major European nations,” said Southard. In Italy, for example, debt exceeds 120 percent of annual gross domestic product. “You’ve got an untenable situation in which the country can’t afford to finance its debt obligations.”
So, too, in the United States where our current debt of $15 trillion is speeding toward $20 trillion. At that point, the U.S. debt will account for 85 to 90 percent of GDP. Even more disconcerting, Southard contends, a recent U.S. congressional supercommittee could not agree on a way to cut just $1.2 trillion in spending over a 10-year period. “I think we’re now approaching a nearly insolvable issue in 2012. We’re going to have a horrendous fight between our two political parties to figure out what’s going to be done to tackle the debt.” That fight, in turn, may force the hand of Standard & Poor’s and perhaps Moody’s to once again downgrade U.S. debt, Southard says.
Further, the travails of Europe, a major export market, and political and economic uncertainty in 2012 will put pressure on U.S. corporations to maintain profitability. That means hiring will stand still and profitability will likely dip. Southard pegs profit growth at U.S. companies at between 4 to 6 percent in 2012, below its historic average, and foresees a market correction of 10 to 20 percent over the next three months to one year.
Greenrock, which supplies investing research to registered advisors and companies, is advising its clients to think long-term and recognize that periods of negative returns are looming. To cope with down markets, Southard says investors should focus their equity holdings on dividend-paying stocks, reduce their bond allocations and move significant portions of their overall holdings to alternative investments. Indeed, Southard is now advising clients to hold 40 percent in equities, 40 percent in alternative investments and 20 percent in fixed income. Recommendations for fixed income and alternative mutual funds include the Altergis Managed Futures Strategy Mutual Fund (MFTIX), the PIMCO Unconstrained Bond Fund (PFIUX) and the Doubleline Total Return Bond Fund (DBLTX).
The water is turbulent. Swim at your own risk.