About Those Calm Market Jitters

Brace Your Retirement Accounts for Wild Ride

This year’s stock market conditions are the polar opposite of what happened in 2008. The year that crazy volatility ruled markets. It was a scary time to be an investor. You might buy a stock on a 200-point rally one day – only to see the market melt-down the next. But the panic-driven wild market ride caused tremendous bargains. Those who pounced on those deep value opportunities have been richly rewarded. Scared markets are opportunity markets.

You are steering through a very different market today. It requires a careful investment approach.

One way to read market volatility is the Volatility Index (VIX). The VIX settled down near historic lows this summer. VIX had some August upside, but nothing dramatic.

Extreme lows in volatility suggest that investors feel comfortable with their choices. A high comfort level is when more people buy on margin. Meaning more people leverage themselves out with more personal risk. And now margin debt is at record levels. These are precisely the conditions to worry about. Buying at these levels could be dangerous.

Market tops are formed out of complacency. Market bottoms are formed out of fear. Quiet, low volatility market conditions shouldn’t make you feel comfortable. The longer they continue to remain calm the more you should be concerned. A lull in volatility doesn’t necessarily mean a reversal. Or that a return to 2008 conditions is imminent. But it does mean that caution is in order.

Watch for It!
Has the Fed Engineered a “New Normal”?

Markets move in cycles. So every time they appear to stabilize, it’s only because they’ve entered that part of the cycle. And not because volatility has been permanently conquered. Yet many investors now assume that the Federal Reserve has put a permanent floor under the market. Lots of people make decisions based on this illusion – that the Fed has tamed the markets. The real issue is when the illusion of a “floor” collapses. And the next bear market takes hold.

The Fed hasn’t permanently dampened market volatility. Nor have they engineered a “new normal” of perpetual investor safety. If anything, the Fed has spawned more extreme market fluctuations. Since Alan Greenspan’s tenure, it has just stretched the bull cycles out longer and longer. And this has led to greater and greater excesses. All leading, eventually, to downturns of greater severity.

John Coates is author of The Hour Between Dog and Wolf: How Risk Taking Transforms Us, Body and Mind. He explains: “Cycles of bubble and crash have always existed, but in the 20 years after 1994, they became more severe and longer lasting than in the previous 20 years. For example, the bear markets following the Nifty Fifty crash in the mid-70s and Black Monday of 1987 had an average loss of about 40 percent and lasted 240 days; while the dot-com and credit crises lost on average about 52 percent and lasted over 430 days. Moreover, if you rank the largest one-day percentage moves in the market over this 40-year period, 76 percent of the largest gains and losses occurred after 1994.”

Current Fed chair Janet Yellen is set to wind down Quantitative Easing in October. That doesn’t mean the Fed will exit the markets. Or return its balance sheet to normal levels. I’st just going to stop buying up new debt – at least for a while .

In past cases when the Fed has ceased stimulus operations, markets have reacted negatively. The stage is set for market unrest to pick up significantly later this fall.

Taking on Market Volatility Is Better than Hiding
Or Losing 99% of Your Money

There are various ways of protecting yourself. Such as hedging against or speculating on a rise in volatility. Most such schemes are dangerous. Take iPath S&P 500 VIX Short-Term Futures ETN (VXX). It has lost more than 99% of its value since its founding.

If the issuers of this crappy product had any shame, they’d voluntarily delist it. But it’s still being promoted by Wall Street. We see it being a loser – except for the most nimble of market-timers.

Riding out market volatility is preferable. Especially as compared to jumping into hedges that don’t work. The most effective hedging strategy is simple. Reduce your exposure to overheated areas of the market.

Diversifying into precious metals and alternative assets is one approach. Parking funds in cash temporarily is another.

You can also rotate into low-volatility stocks. They’ll give you exposure to an upward trending market. And limit (though not eliminate) your downside risk – should markets start tanking.

Low-Volatility ETFs: Buy for Upside
While Lessening Downside

In the June 2012 issue, I introduced you to PowerShares S&P 500 Low Volatility (SPLV). The ETF holds the 100 least volatile stocks in the S&P 500 (as measured over a trailing 12-month period). The portfolio of safe and steady selections has a beta of 0.84. Which means it’s about 84% as volatile as the S&P 500. SPLV yields about 2.8% – slightly more than the S&P 500.

But why focus just on U.S. stocks? Most foreign markets offer better values and higher yields. One of the knocks against foreign markets is that they can be more volatile. We’ve certainly seen a lot of volatility emanating from Russia, as well as other parts of the world this year. Fortunately, there are also lowvolatility
instruments that focus on foreign markets.

Consider one or more of these instruments. They can set you up for superior foreign equity growth. And all with less downside risk:

  • iShares MSCI Emerging Markets Minimum Volatility (EEMV)
  • iShares MSCI All Country World Minimum Volatility (ACWV)
  • iShares MSCI EAFE Minimum Volatility (EFAV)

We are watching markets very carefully. Watch for next month’s report to you.