Part of the new normal for investors is getting used to more volatility.  – Eric Jackson

At any point in time there is never a shortage of analysts willing to argue that the stock market is overvalued or undervalued.  Until recently, few have had much to say on the topic of volatility and the stock market.  Now that volatility has once again returned to the stock market it begs the question:  Is this necessarily a bad thing?

As we argued last week the one-way bet in equities that lasted for the better part of two-plus decades has given way to fears about the increasingly turbulent global macroeconomic situation.  Some even argue that the search for diversification in this morass has become futile as investors pile into supposedly safe assets like gold.

This increased market volatility has set off a slew of posts on the topic. Let’s quickly recap some of the findings.

  • CXO Advisory Group finds no evidence for volatility to filter “good” or “bad” market days.
  • Mark Hulbert finds “no statistically significant relationship between periods of high volatility and the market’s subsequent direction.”
  • This paper by Weigand, Gorman and Sapra finds that volatility and alpha dispersion are correlated.
  • Mark Hulbert (again) finds that momentum strategies perform best in times of relative market calm.

Taking these findings at face value tells us two things.  One, volatility has little to tell us about the future performance of the stock market as a whole.  Two, volatility could be a useful signal in constructing stock selection models.  This is contrast to what Felix Salmon argued in a piece last week that volatility really doesn’t provide any useful signals for stock selection.

Salmon goes on to argue that not only should volatility push investors away from the stock market so should the equity risk premium or lack thereof.  Commenting on an Eric Falkenstein blog post, Salmon writes:

This is the heart of my case against investing in stocks. For one thing, you have no good reason to expect an equity premium going forward, and if there isn’t an equity premium, then your allocation to stocks should be tiny: you’re not being compensated for the extra risk you’re taking. On top of that is the question of volatility, which is not exactly the same as risk, but which again should be compensated for with higher returns, and isn’t.

If you believe that the equity risk premium is low (or zero) there is little or no reason to make a passive investment in the equity market.  In short, there is no there, there.  This argument isn’t new to any one reading Abnormal Returns as we focused on this line of thinking last yer.

Eric Falkenstein notes the many ways in which our thinking on the nature of risk and return in the equity markets is all mixed up.  Rather than there being some sort of monotonic positive relationship between risk and return, Falkenstein believes our risk-seeking behavior tends to blow this relationship up.

Even if you believe like Salmon or Falkenstein that there is little or no equity risk premium it does not necessarily follow that you should ignore the stock market altogether.  If you believe that  market volatility is in excess of the volatility of equity’s underlying fair value then by definition there have to be alpha opportunities. Said another way if assume that a stock’s value is relatively stable then if the market is wildly gyrating there are going to be times the stock is both under- and over-valued.

Last week we hypothesized that an active approach to stock selection could take advantage of this very situation.  We wrote:

In short, you can’t beat the computers at their own game.  Instead you need to play an entirely different game.  One that puts a longer-term focus on individual companies and their underlying values.  Otherwise the volatility inherent in this kind of market will eventually wear you down or wipe you out.

Then again nobody said it would be easy,  Falkenstein weighs in:

In reality, you either have to hope for lady luck, or actually do a lot of work finding your investing alpha looking for subtle patterns, or like Warren Buffet actually manage the companies you own to perform better than average. The idea that a passive approach to equities implies higher-than-average returns puts you at the mercy of brokers who may be selling diamonds in the rough, but usually are selling hope…

Stock picking is hard, but if you don’t want to stick all your money in TIPS, it may be one of the few ways to make money in what some people believe will be difficult times over the next decade.  So while volatility may create opportunities, it also serves a useful purpose as a warning to investors.

Rolfe Winkler notes how much of the uproar surrounding the flash crash has to do with the attendant increase in market volatility.  He argues that volatility in and of itself may be a useful thing:

Besides, volatility is healthy. The “Great Moderation” in the years running up to 2007, notably the extreme predictability of U.S. monetary policy, led to complacency and, ultimately, the credit crunch. Unexpected drops remind investors to operate with healthy margins of safety. That’s a lesson of the recent crisis that no-one should try to regulate away.

We live in an increasingly interconnected, complex world filled with the potential for volatility.  If a step-up in market volatility forces investors to think long and hard about whether their investments are both appropriate and have some margin of safety then it will have served its purpose.

*Falkenstein himself provides some strategies that do seek to outperform the market by exploiting investors penchant for risk-seeking.  Minimum-risk portfolios and beta arbitrage are two examples he provides.

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