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October 19, 2014

Beyond the Volatility

If the volatility we’ve been experiencing as of late feels like a splash of cold water, it’s likely because it’s been a while since we’ve really experienced it. An extended stretch of calm waters preceded the U.S. market’s recent bout of volatility.
I’m going to share with you some updated numbers from what we crunched for last week’s AAII Dividend Investing update to put things in perspective. We use the iShares Dow Jones U.S. Index ETF (IYY) as the benchmark for both our DI and for our Stock Superstars Report portfolios. This ETF tracks the performance of the largest 1,260 U.S. stocks, giving it exposure to a combination of large-, mid- and small-cap stocks. This ETF incurred daily price changes of 1.5% or more 62 times in 2011 (29 days up by 1.5% or more and 32 days down by 2% or more.) For the entire period following 2011, meaning January 3, 2012, through yesterday, October 15, 2014, the ETF experienced a total of 39 days with a daily price change of 1.5% or more (20 down and 19 up). Again, 62 days in 2011 alone versus just 39 days for the nearly three-year period of 2012 through 2014.

Let’s look at the volatility another way. Wayne Thorp, who maintains a dashboard of market indicators for our Computerized Investing service, has been tracking the number of 1% down days for the Dow Jones U.S. ETF since 1999. Through Wednesday, he counted eight 1% down days over the last six months. This is below the median of 17 days and the average of 19 days with drops of 1% or more since 1999. (Wayne elaborates on this indicator in his Editor's Outlook in the October Computerized Investing email newsletter that is being sent out this weekend.)
We’ve enjoyed the calm and now we’re having to adjust to what is, at least for right now, rougher waters. Whether the current bout of volatility represents a reversion to the mean or something else is open for debate. What I can tell you is that large-cap stocks are now in a pullback (a decline of 5% or more) and small-cap stocks are in a correction (a decline of 10% or more).
Our decision not to extend the current bull market through the end of the third quarter for the purpose of calculating performance for both mutual funds and the AAII Stock Screens reflects the uncertainty caused by the data. As we discuss in the upcoming Quarterly Low-Load Mutual Fund Update newsletter, the average third-quarter returns for funds in the mid-cap category, the small-cap category, all international categories and the majority of sector stock categories were negative. We want to see if the third quarter’s and this month’s returns turn out to be just a temporary dip or the start of a new phase for the stock market.
There’s no denying the worrisome headlines floating about. Ebola is spreading, the Ukrainian crisis has not been resolved, ISIS is organized and is funding itself through black market oil, the European economy remains stagnant with deflation still a threat, earnings estimates for U.S. companies have been falling and economic growth isn’t great here either. On the other hand, prices at the gas pump are falling, the dollar is stronger, the U.S. economy is still expanding, companies are fiscally sound, interest rates remain low and stock valuations, while not cheap, aren’t expensive.
As humans, we tend to project current events as continuing into the future (“recency bias”) and feel the pain of losses more than we derive pleasure from gains (“prospect theory”). Given these emotional tendencies, the hyperbole that gets used by the financial media and the relative calm market conditions we had been enjoying, the recent volatility doesn’t feel good. But stocks are volatile assets. They can fluctuate quite a bit over the short term. Over the long term, however, the higher returns compensate you for putting up with the short-term volatility.
The Week Ahead
Third-quarter earnings season will hit full stride next week with more than 125 S&P 500 members reporting. Included in this group are Dow Jones industrial average components International Business Machines (IBM) on Monday; The Coca-Cola Company (KO), McDonald's Corp. (MCD), Travelers Companies (TRV), United Technologies Corp. (UTX) and Verizon Communications (VZ) on Tuesday; AT&T (T) and The Boeing Company (BA) on Wednesday; 3M Co. (MMM), Caterpillar (CAT) and Microsoft Corp. (MSFT) on Thursday; and Procter & Gamble Company (PG) on Friday.
Tuesday will feature the week’s first economic report of note, September existing home sales. The September Consumer Price Index (CPI) will be released on Wednesday. Thursday will feature the October Purchasing Manager’s manufacturing index flash. September new home sales will be released on Friday.
Federal Reserve Governor Daniel Tarullo will speak publicly on Monday.
The Treasury Department will auction $7 billion of 30-year inflation-adjusted Treasuries (TIPS) on Wednesday.
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)

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