Lessons from stock-market volatility

By Felix Salmon
August 10, 2011

Didja see? Stocks went down, and then they went back up again. If you just spent the entire period lying in blissful ignorance on a beach, then you would have saved yourself a lot of stress and panic. And there was very little in the way of actual news, either. The scandal isn’t that S&P might have told banks and hedge funds it was going to downgrade the US: the scandal is that S&P told everybody, repeatedly, that it was going to downgrade the US, and the markets ignored the news until it actually happened. Similarly, there’s precious little actual news in the FOMC statement — certainly not enough to move the market by 5%.

So as ever, the best thing to do, if you’re saving for the long term, is to just keep on putting a small amount of money into the stock market every time you get your paycheck — and to ignore short-term stock-market gyrations. The stock market, at some point in the future, will be lower than it is now. And at some other point in the future it will be higher than it is now. We mere mortals can’t hope to time such things.

All we can really hope to do is put our money somewhere where it’s more likely to earn a decent real return over the long term than it is to get eroded away. And there’s simply no way that bonds or cash are superior to stocks on that basis, given their current yields of zero.

Obviously, the stock market is a dangerous place for short-term speculation — and if you can’t afford to see a 5% drop in one day, or a 20% drop over the course of a few weeks, then you shouldn’t be investing in stocks at all. It’s not a place for money you’re likely to need to spend any time soon. But if you’re a long-term investor, the one advantage you have over the big institutions is that you don’t mark to market, and are therefore less likely to be forced to puke up liquid and valuable stocks when markets fall. Take advantage of that, stay calm when markets get volatile, and over the long term you’ll be glad.


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It worked in the 90′s…
If you take the derivate over time of the moving average over 10 years of a stock market index (s&p 500 for instance), it will show you your expeceted return. In the 90′s, the MA(10years) was moving up, so no problem about expected return being higher with regular investments. However, since 2000, the MA(10 years) is flat. So over a 10 year period your expected return is 0 (derivate of the MA(10)). So right now, I wouldn’t advise anyone to save a little bit of money in the stock market every month. The “some point in the future” can take decades.

Posted by Matt_800 | Report as abusive

“Stocks went down, and then they went back up again.”

They retraced a portion of Monday’s loss. That isn’t “back up”. Not yet, at least.

“saved yourself a lot of stress and panic”

Who was panicking? And my only “stress” was in wondering what would constitute a once-in-a-lifetime level that would demand that I grub up additional cash to buy more.

“The point here is that volatility alone is reason enough to exit the stock market.”

You wrote this last May, just before the market spiraled 25% higher over the next year. I see you have changed your tune…

Posted by TFF | Report as abusive

I told you things would be clearer on Wednesday! See how much more relaxed you feel now? Was all that stress really necessary? You’re right Felix, Long Term Investors should look at things differently to Short Term Traders.

Where I see the next long term issue is with the demographic time bomb… the change from Baby Boomers with salaries to Baby Boomers with pensions. This usually results in a 30% plus drop in income to match the expected drop in necessary spending and discretionary investment. This spending has supported the economy for decades – what effect will its loss have on ongoing growth?

Posted by FifthDecade | Report as abusive

Yesterday’s move was a temporary reaction to the Fed’s announcement that they were keeping rates low through 2013. After that emotional exuberance, markets will come to realize that cheap borrowing does not create demand in the sort of situation we’re in, and the spending cuts already under way from previous agreements made with the Tea Party Republicans earlier this year are coming to roost.

Posted by GRRR | Report as abusive


Market has always headed higher over time. It does not have to be that way in the future.

I don’t understand why people in your position don’t recommend that their readers learn to use options to hedge risk.

I teach people to use options. Not to gamble. But to reduce the risk of holding investments. I am not talking about buying puts – a very expensive proposition.

Posted by MarkWolfinger | Report as abusive

“Market has always headed higher over time. It does not have to be that way in the future.”

As long as corporations are profitable, the market SHOULD trend higher over time.

Several reasons why people are beginning to doubt this:

(1) Back in 1999-2000, the S&P500 was trading at a P/E over 40. That implies a return on your investment (if you were to buy the company entire) of just over 2%. No surprise that people confuse 2% with 0%.

(2) Financial sector earnings, which came to dominate the S&P500 over the last decade, are ephemeral. Those companies that operate real businesses have more than doubled their profits. But when people look at the market averages, they lose sight of the diversity within the index.

(3) The retrenchment in the P/E from over 40 to under 20 has (relative to profits) cut the price in half, erasing the gains that the earnings increase would normally generate. You could argue that this retrenchment in P/E might continue indefinitely, but the lower it falls, the higher the implied coupon on the security (as well as the more tangible dividend).

The average P/E on my portfolio is around 13, and while the earnings aren’t likely to grow rapidly, they aren’t about to evaporate any time soon. Looking a decade ahead, there is very little risk when investing at a P/E of 13.

Posted by TFF | Report as abusive

Felix, if you’re going to comment casually about the futility of market timing, you should do it more than a few days after headlines like “Buy stocks, sell bonds” (written in response to specific market events).

Yeah, that was really advocating portfolio rebalancing… but really sounded like an excuse for a market timing trade.

Posted by absinthe | Report as abusive

Except that Teh (all knowing) Market did the opposite of what S&P said. S&P said T-bills are worth less because of The Deficit. The market said, Deficit bullshit, stocks are worth less because the economy is contracting (not growing etc.) so let’s buy T-bills.

Posted by msobel | Report as abusive

The problem with S&P is a documented looseness with the truth. The SEC and the Senate Banking Committee have a clear duty to initiate investigations.

Thomson Reuters: S&P balks at SEC proposal to reveal rating errors

[The letter was sent three days after the U.S. Treasury Department accused S&P of miscalculating -- by some $2 trillion -- the U.S. debt in the next 10 years. That calculation was in a draft press release announcing a downgrade in the government's credit rating from AAA to AA-plus.

S&P vehemently denied it had made an error, but acknowledged that it changed its long-term economic assumptions after discussions with the Treasury Department. It switched to another economic scenario that resulted in a debt load $2 trillion smaller by 2021. But it said that did not affect its decision to downgrade the U.S. debt.]

http://abcnews.go.com/GMA/video/sand-dow ngrade-blamed-debacle-washington-1425358 9

Posted by ClaytonBurns | Report as abusive

Fortune at CNN: S&P president: Obama knows the problem is serious By Katie Benner August 9, 2011: 9:48 AM ET

[S&P's competence has been called into question by the Treasury because of a $2 trillion error that your analysts made when they looked at the U.S. debt situation.

Let me clarify. This was not an error. It was a change in assumptions based on conversations we had with the issuer. That is part of the ratings process for any credit [including corporate, sovereign, and structured credit]. We talk to the issuer. If they have feedback, we listen. If we agree, we have no qualms about saying that we will adjust our analysis.

In this case, the Congressional Budget Office had different scenarios for discretionary spending growth, and we picked the scenario by which discretionary spending grew at the same rate as GDP. Then the Treasury pointed out that the budget act caps discretionary spending growth at the rate of inflation. After further conversation with the Treasury and CBO, we agreed with them and adjusted the analysis.

But that adjustment wasn’t enough to change our minds. Today, America’s debt level is 74% of GDP, or $11.4 trillion. Our initial assumption was that it would grow to $14.7 trillion in 2015. After we adjusted our analysis, we still see debt hitting 14.5 trillion in 2015. The debt is still rising, and moving to an unsustainable level, which the president acknowledged.]

This narrative is just not convincing. It is not even internally consistent. President Obama has to challenge S&P’s narratives and complete the job by ensuring that the price is fully paid. S&P can’t even get the support of National Post columnist Terence Corcoran, who alludes today to “a haywire ratings downgrade by Standard & Poor’s.”

Posted by ClaytonBurns | Report as abusive

Now, this smacks of the usual broker’s hype to small investors with a condescending pat on the head.

The market is still down well over twenty percent from three years ago. Is that part of the short-term canned speech? To most brokers that’s not just long-term, it’s an eternity. We are still down by trillions.

Want to revise your philosophy about near-term and long-term investing?

It’s a good thing that the privatizing of social security didn’t happen or millions of people would be in even worse shape.

Try again Cat Fish.

Posted by ptiffany | Report as abusive

1:22 P.M. Dow down 324.

After telling us that stock market volatility is unexplainable, you’ve now cheerled the stock market on the basis of a single positive day yesterday. (You’ve cost me millions!)

I read you every day for your many knowledgeable observations about the contemporary economic scene. Really. But I do not read you to tell me “Now’s the Time to Invest! Stocks are a Bargain!” Especially when you acknowledge that you haven’t a clue about why the stock market does what it does.

I guess we get it, Felix. You’re an optimist.

Posted by jbernar | Report as abusive

“I find Bodie’s argument the most compelling; if stocks are less risky in the long run, put options should be less expensive.”

Is there a market in 30-year put options? I can’t find any listed for the SPY with an expiration beyond 2013. To me, it seems intuitively obvious that the uncertainty in the market two years from now (either up or down) is greater than the uncertainty in the market next week. Note also that the SPY does not account for dividends, which represent something like half the long-term return of stocks.

Yet the earnings stream ought to exert a persistent upward bias. A broad uncertainty around a higher result may nonetheless trump a narrow uncertainty around a lower result. This is particularly relevant in today’s bond environment, with long-term expected returns that are less than 1% ahead of inflation.

“Besides, what happens if when I retire I stumble across a market like this one?”

Your typical retiree faces a life expectancy of 20+ years, and must plan accordingly. If you fund your retirement through asset sales, or if you hold the majority of your assets in cash/bonds, you will have a VERY hard time keeping up with inflation through retirement. Conventional advice is that a 4% draw rate is sustainable for retirement. In the present market environment, following conventional asset allocation, that may be too high.

Yet a 3% draw rate can be sustained WITHOUT asset sales, simply by holding high-quality dividend stocks. And that dividend income has a better chance of rising with inflation than bond income would offer. That might not be an optimal plan, but it seems safer to me than the alternatives.

“The market is still down well over twenty percent from three years ago. Is that part of the short-term canned speech? To most brokers that’s not just long-term, it’s an eternity. ”

Three years is an eternity?!? If your investment horizon is shorter than five years, you have no excuse for playing in the stock market in the first place!!! And when the market is trading at a 25+ P/E, as it was then, you probably ought to anticipate negative ten-year returns. The positive earnings bias works much better at lower P/E ratios than at higher P/E ratios.

Posted by TFF | Report as abusive

Felix, MarkWolfinger is right. Even if you follow your ups and downs theory this was NOT a SUDDEN crash. Every riskmanager should have been alert in July and have noticed that “a last minute deal” by US government was risky business. Even put options would not have been out of order. You take an insurancy on all other stuff that you have as well (I hope).

Posted by FBreughel1 | Report as abusive

Hey Felix,

Remember when I said yesterday’s blog was your all time best out of the thousands you’ve written…

…this one just topped it. You should be on CNBC calming everyone down after Kramer. At the end of every show you could showcase a reasonable bottle of wine… I’m telling you this could be ratings gold!

Posted by y2kurtus | Report as abusive

Hi Felix,

I need your advise. Given the high volatility in the market now, do you think I should go ahead and buy a Dow 10K hat? I see that it’s still available on Amazon. It’s only $18 but I’m afraid that the Dow may climb back up again from here, and I may never be able to wear it. I don’t know… Maybe I should look at it as a long-term investment like you suggest in your post; that is, “more likely to earn a decent real return over the long term”. I might not be able to wear it this month, but I’m sure at some other point(s) in the future I will be able to. What do you think?

Posted by Dyske | Report as abusive

As you mention, Felix, dollar cost averaging is a time-honored investment practice. I have a pension plan that operates on that premise.

On the other hand, I have my pension money in a self-directed account through TDAmeritrade. It allows me a much wider selection of investment choices. I like LGPSX, a no load fund that allows me to enter and exit whenever I choose.

In my opinion, TDAmeritrade should allow me to make instantaneous moves with my mutual funds like my Scotttrade account allows for individual stock trades, but as you surely know, mutual fund transactions are only conducted in the after-hours market. There ought to be a law against that. I understand that when mutual funds first became popular investments, it wasn’t technically feasible to instantly shift allocations, but times have changed.

I know better than to try to guess which way the market is going on a day to day basis. I have moved my money 100% out of stocks only twice since 2007. In October of 2007, I closed out all of my stock funds and put them 100% into bonds. I advised my coworkers to do the same. It wasn’t until several months later that anyone realized that October 2007 was the all time high in the stock market. I could have done better with picking the bottom, but I did all right. I was able to forgive myself for being a little too pessimistic about the market’s trough.

Because of the kind of work I do, I can’t conduct these transactions unless I’m not working on a particular day. Then I like to wait for the end of the day so I have an idea what the market is really going to close at.

For that reason, I got out of the market again a couple months before the end of QE2. I knew I was probably exiting early but I was anticipating another big drop and I didn’t want to get caught holding the bag.

This time, I moved 100% out of stocks and into a 100% cash position because the bond market didn’t look as safe to me as it did four years ago. I missed a little upside, but like I said, I’m usually not in a position to watch the markets when I’m at work and I can’t conduct transactions from work. It was worth it to me to be safely in cash while waiting for the big drop. I again warned my coworkers to get out of stocks. I have only warned them away from stocks twice and I was right both times. I’m proud of that and I have records to prove it.

I was only a little disappointed that the recent plunge took so long to arrive, but it’s here at last. I think the debt ceiling debacle delayed the inevitable by taking everyone’s focus off what was happening in Europe among other downside factors.

I’m still 100% in cash and I have a little anxiety about missing a move up in the next couple days, but I think any upside move that comes along this week will be a short-lived optimist’s pipe dream. I’m taking a couple weeks off from work beginning next week and I hope to come fairly close to picking the market bottom during that time.

I hope the European witch’s brew comes to a boil quickly. Trichet added some cold water to the concoction to cool it down but Angela Merkel is pretty unhappy about that and there is still a lot of unburned wood in the fire. The Chinese have a cauldron on the fire, as well, but it would take a little kerosene to bring that one quickly to a boil.

Double, double, toil and trouble
Fire burn, and cauldron bubble

Posted by breezinthru | Report as abusive

BTW, I believe that the drop in the market has very little to do with the S&P’s downgrade in spite of what a lot of pundits are saying. The downgrade was just a coincidental event that happens to reflect a lot of real, underlying downside factors that are exerting sustained harm and risk to our economy.

The stock market sometimes responds to a harmful economic environment by dropping and sometimes by closing its eyes to the harm and focusing on a few strong earnings reports. The market and the economy aren’t connected at the hip like it seems they should be.

Posted by breezinthru | Report as abusive

setting aside the flaws on your own analysis (there is no statistical or scientific way to dicern a AAA vs AA rating, historically neither have defaulted), a country with debts in its own currency and ability to print fiat money cannot default. France, Ireland, and Greece can default (debts are in Euro), the U.S and Japan
can’t. WHich is why the Japanese downgrade meant little.

Yes, that means if push came to shove, mustering the political will to inflate away the debt and print money, but ultimately thats what governments end up doing. Not that its going to happen anytime soon in the U.S. or Japan.

Posted by dwb3 | Report as abusive

“I believe that the drop in the market has very little to do with the S&P’s downgrade in spite of what a lot of pundits are saying.”

Agreed. As I wrote a week ago, the market was positioned for a big drop — the debate over the debt ceiling may have triggered that drop, but it didn’t create the conditions.

Am beginning to see reasons to buy again, though.

Posted by TFF | Report as abusive

TFF wrote “Agreed. As I wrote a week ago, the market was positioned for a big drop — the debate over the debt ceiling may have triggered that drop, but it didn’t create the conditions.”

Well I am of the mind that the conditions that created the big drop are all there and will be for a very long time. I may be wrong, but I am more concerned about my age and my future.

I feel lucky to have exited everything (sadly I have some retirement funds that aren’t self directed) the week before the drop and I am not returning until I see those conditions change. (and I am one of those who held steady and never, ever panicked)

Posted by hsvkitty | Report as abusive

hsvkitty, it really depends on whether you expect “slow growth” or “no growth”. If you expect “slow growth” in the global economy (not necessarily the US and Europe), then there are already bargains on the table. If you expect the global economy to shrink, or to completely stagnate, then we should expect prices to fall further.

I started buying again yesterday, and will continue to buy as money comes in as long as the market stays in its present range.

Buffett also claims to be buying.

Posted by TFF | Report as abusive