In my column two weeks ago, I discussed the concept of expecting financial markets to be uncertain and to learn how to capitalize on volatility rather than being a victim. Of course, the idea for that article was primarily the very sharp intraday market drop that occurred on May 6, which is now known as the “flash crash."
Of course, it was not really a market crash other than the unusual magnitude of the move within one trading day, since the prices recovered the majority of the losses by the end of the day. Volatility has persisted throughout the month of May, and I suspect it may be with us for a while longer as nervous investors choose to either take advantage of dips in prices to buy or to take advantage of rises in price to sell and get some relief from the mental duress they may be under.
When extreme bouts of volatility hit the financial markets, it is generally at times when investors are fearful. Because we react more to the fear emotion than to rational moments or greed, the extremes of fear can be measured by monitoring trading activity and the related details such as price and volume. I won’t get too technical, but wanted to share the chart below of the S&P 500 Volatility Index. The S&P 500 is a widely used measure of stock market activity, and the index itself is composed of the 500 largest corporations by worth in the U.S.
If you note the times in the last 20 years when the Volatility Index reached peaks in the 35 – 40 range or above, they were generally great times to be accumulating equities for gains in the next one to three years. But, of course, these are the times when most investors are running for the bomb shelter and staying away from investing in stocks.
The table below lists gains for the S&P 500 index (not including dividends) from the approximate peak in the high volatility range for the following 12 months:
10 / 1990 - +59 percent
10 / 1997 - +20 percent
09 / 1998 - +26 percent
09 / 2001 - -21 percent
10 / 2002 - +18 percent
10 / 2008 - +20 percent
The average gain in the year following a volatility index spike to near 40 or above is 20 percent (not including dividends) and five out of the six cases were positive returns. The one loser was the volatility spike occurring as a result of the terror attacks on 9/11, an exterior shock which occurred before the stock market correction from the Dot. Com and technology stock bubble had fully run its course.
It is also worthy to note that the spikes in volatility did not mean the market had bottomed yet. Particularly in 2002 and 2008, the market proceeded lower before finally moving significantly higher in 2003 and 2009 respectively. The message here is one of seizing opportunity when others are fearful, a behavior exhibited by many successful investors. But, one should never lose sight of a common sense investment plan and in no way should the content in this article be taken as an exact timing mechanism. As identified above, patience may be required before gains are realized.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing.