- KPB & Co Research
Before we answer the question, let us get a few things clear. When we refer to volatility we refer to the day to day movement in stock prices. On high volatility days you will likely see a bigger gap between the highest stock price of the day and the lowest stock price of the day, and vice versa. It follows that we use expected volatility to mean, what Mr. Market believes will be the day-to-day movement in stock prices in the coming year. We measure volatility by using the CBOE Volatility Index (VIX), a benchmark compiled and published by the Chicago Board of Options Exchange (CBOE). This benchmark is calculated by finding out the day-to-day movement in stock prices that is assumed by Mr. Market, when he/she calculates the fair value of Put option and Call option on stocks.
Just one more thing. Over the last 10 years, and particularly after the 2008 recession the CBOE Volatility Index has been on a downward trend, coming from a high of 80 to a low of 9. Many people believe that this event is unfamiliar territory for the market, in light of the fact that since we began tracking the CBOE Volatility Index it has never happened. In the period 1990 to 2000, the VIX fluctuated range bound between 10 and 50. Keep in mind that market volatility exists the day people began to buy and sell stocks, so and though the event didn't occur in the last 28 years, the event may have occurred sometime before that. You may be asking why did this happen? There are many explanations, none of which are conclusive. The most popular reason given is the unprecedented policy combination of Quantitative easing, and zero interest rates by the US Federal Reserve. Some analysts argue that the rise of passive investment managers who habitually bought assets without consideration for fundamentals, and the rise of technology companies which became more dominant in the index as their valuations got bigger played huge roles.
Volatility bottomed out in mid 2018, and then began to rise from a 28-year low, which has many implications for your portfolio. First, fundamental information flows should play a larger role in determining entry or exit points. In any market scenario, one ought to be cautious about where one buys and sells, in high volatility environments the level of caution has to be doubled. Stocks will move down or up very quickly, and these movements provide little or no information on the direction of trends. At the end of the day, stock prices reflect the profitability of a company, which in turn is impacted by fundamentals such as corporate strategy, market demand, or operational excellence. Second, higher volatility will lead investors to ask for a higher discount on stocks, and so to avoid being a loser, you should be very conservative with your valuation estimates. This problem is compounded by the fact that we are in a rising rate environment, which reduces the attractiveness of stocks relative to alternatives such as variable rate or short-term debt. Third, be very careful in the use of leverage, margin loans or whatever nomenclature that represents borrowed money. As stock prices swing wildly, the chances of you getting a call from your bank to cover your loan gets higher. In a worst-case scenario, the bank may ask you to sell your stock at market price - which given the volatility may be a 52- week low. As you bleed the bank will say sorry and then try to sell you another product... the quadruple protector insurance plan perhaps?
As uncertainty in the Trump era rise for good or bad reasons, the key message we would like to leave with our readers, is to keep your nerve. Fundamentals are even more important today, and you can rest assured that in the long run stocks usually move towards intrinsic value. As long as you don't pay high prices for good businesses you will probably be ok.