Don’t panic over stock market moves.
A volatility spike in U.S. stocks in the past couple of months eliminated 2018 gains and left investors uneasy about the prospects of a bear market. The S&P 500 index is down 10 percent since October 1, while the CBOE S&P 500 Volatility Index (VIX) jumped 54 percent. Volatility is often used as a gauge of fear in the market, but Nicholas Colas, co-founder of DataTrek Research, says volatility is healthy for the market. Colas recently compiled a list of 10 reasons investors should be thankful for the recent whiplash.
Volatility is a wake-up call.
Colas says there’s no such thing as a free lunch on Wall Street, but the lack of volatility in recent years may have caused some investors to forget that rule. The S&P 500 roughly tripled since its 2009 lows, and market volatility has been near record lows throughout most of the past two years of that run. Stretches of relatively high, predictable returns with no volatility lull investors into a false sense of security, and it’s in these times that investors tend to make mistakes by taking on too much risk.
Volatility provides feedback for companies.
In a capitalist market, companies are always experimenting with new approaches and new business strategies, and the free market decides which strategies are winners and which are losers. When the stock market steadily marches higher no matter what corporations do or how they put their money to work, it can seem as if all ideas are genius ideas. A bit of market volatility can apply the type of pressure corporations need to trim the fat and stay focused on their best ideas. These best ideas are the ones that benefit investors most in the long term.
Volatility evens the playing field.
Colas says periods of volatility give retail investors a fighting chance against high-powered Wall Street trading algorithms. He says the majority of high-frequency algorithms are tied to past market performance, and most are heavily influenced by the past 100 days of market activity. Human investors, however, have the potential to take a longer-term perspective when it comes to the market. Algorithms rely on numbers and trends, but Colas says long-term investors can recognize subtle shifts in market conditions. Human investors are also able to consider new and unique information that may not be incorporated into high-frequency algorithms.
Volatility creates churn.
A look at a longer-term price chart of the S&P 500 reveals periods of short-term volatility in every bull and bear market. These volatility patches may seem like random noise in the market. But while the daily trading patterns are often extremely unpredictable during these periods, an important fundamental shift is happening under the surface. Investors tend to be fearful during periods of volatility and often sell their largest holdings or rotate out of the best-performing stocks. Colas says these reset periods eliminate short-term traders that are not committed to the long term.
Volatility is a signal to policymakers.
The market doesn’t only provide feedback to corporate management, Colas says it also provides a real-time gauge of what investors think of monetary policy, government regulation and political legislation. The stock market may be the closest thing American policymakers have to a real-time referendum on the political headlines of the day. When investors believe policymakers have made a misstep that will create risk in the economy, the first thing they do is sell risky assets, such as stocks. Policymakers are then forced to either defend their positions to the public or change course.
Volatility keeps excess in check.
One of the most consistent predictors of economic recessions is patches of excess in financial markets, such as excess in the housing market prior to the most recent U.S. recession. These excesses tend to build up during periods in which investors see relatively low risk. While stock market volatility is often a signal of a bursting bubble, Colas says periods of volatility can also keep bubbles from forming in the first place. Investors may not like periods of volatility derailing potential market booms, but they also help prevent the subsequent busts from being as destructive.
Volatility stress-tests financial technology.
For the past 10 years, new ideas in financial technology and money management have been introduced into an extremely friendly environment. Colas says robo advisors are a prime example of an investing trend that has largely gone untested since its conception. Almost any investing strategy can make investors money during a calm bull market. Companies and strategies that have produced huge returns for investors are often exposed as one-dimensional during times of extreme volatility. At the same time, strategies and technologies that can handle the volatility stress test are validated and give investors even more confidence in their long-term viability.
Volatility is a reality check for venture capitalists.
Colas says market volatility forces venture capitalists to take a more realistic approach to valuing startups and potential initial public offerings. The current bull market has been extremely generous to high-growth companies, regardless of high valuations, profitability or debt load. Growth companies have a large margin for error during periods of market prosperity. However, companies that need large amounts of capital to grow their businesses over time may find that capital hard to come by if lending markets tighten. Colas says it’s healthy for VC firms to think twice about a company’s valuation before going all-in on an investment.
Volatility encourages active investment.
The rise of exchange-traded funds in the past decade is partially driven by the fact that investors haven’t needed to be selective about buying only the best stocks to get decent returns. In 2018, a standard passive S&P 500 index fund finished the year down about 9 percent. The year-end volatility may force funds to reconsider their holdings and their strategies, and it may force some investors to consider rotating money away from passive investments and taking a closer look at which stocks are undervalued and which may be overvalued.
Volatility facilitates functional capitalism.
Colas says the proverbial “invisible hand” of a market is driven in large part by fear of losses, and those fears are stirred up during periods of market volatility. Without fear of loss, too much risk-intolerant capital can work its way into high-risk investments. In those instances, extreme measures such as government bailouts may ultimately become necessary to save the economy. These types of events can also cause investors to lose faith in the system and keep their money out of the market, and capital investment is the fuel that a free market economy needs to grow over time.
Why volatility is good for the stock market.
Here are 10 reasons why investors should welcome volatility in the market:
— Volatility is a wake-up call.
— Volatility provides feedback for companies.
— Volatility evens the playing field.
— Volatility creates churn.
— Volatility is a signal to policymakers.
— Volatility keeps excess in check.
— Volatility stress-tests financial technology.
— Volatility is a reality check for venture capitalists.
— Volatility encourages active investment.
— Volatility facilitates functional capitalism.
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10 Reasons Volatility Is Good for the Stock Market originally appeared on usnews.com
