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Seeking a New Understanding

by on September 06, 2015 3:05 AM

I turned on CNBC Tuesday morning and the futures were indicating that the Dow Jones Industrial Average was expected to open down 426 points.

Since we entered late summer and now September, the stock market has become more volatile, moving more than 100 points on the Dow Jones Industrials a number of times. 

All this volatility is measured by the VIX, which until August was a very quiet index. Now the VIX has shot up to a reading of over 50 after having a range of only 10 to 20 for a long time. Importantly, the volatility of our domestic stock market is echoed in foreign markets too.  China, Japan and Europe have also become more volatile. So after a long quiet period, investment prices are much more unsettled.

There are a few notions that are important for investors to remember. First, investment prices are always set by the buyers, not the sellers. When the market becomes more volatile it means that buyers are not committing new money to the stock market as fast as sellers are willing to unload stocks for cash. When buyers pull back, stock prices decline. So after all the monetary stimulus (putting extra cash in investors’ hands) around the world, buyers are getting more cautious and stock prices are declining. 

Secondly, stock prices are generally self-limiting functions.  This means that when stock prices rise or fall quickly, the likelihood of the stock continuing in one direction declines.  This doesn't mean that a stock price cannot demonstrate a nice trend either up or down, only that sharp moves in either direction are usually constrained.  Usually does not mean always; keep that in mind also.

Lastly, a considerable number of investors have moved from a generally consistent understanding of the forces determining stock prices to an era where a new understanding is required.   Either your story about the markets is consistent with the movement of stock prices or it is not.  If your story doesn't explain what is happening, you will step back from committing your funds and search for the story that will explain the new reality so that you can devise an investment strategy that will allow you to prosper. 

During periods of high volatility the stories about the market are changing and uncertain.  You hear it in the conversations about the markets: What is happening?  Why are stock prices declining?  You think to yourself, “I could lose all of my money!  It must be time to sell!”  Investors rarely have these conversations when stock prices are rising at a sustainable clip.  When stock prices are rising, everyone thinks they know what is happening because there is no pain for being wrong.  If you are out of the market when it is rising, that lost opportunity is much less painful than real losses resulting from selling when stock prices decline.

So what is an investor to do in this environment?  This is a great time to raise some cash carefully, so that you have cash in your investment account to buy as the markets settle.  Next, start your investment research by noting which stocks are doing relatively well and which are declining sharply.  Sooner or later, new investment leadership will emerge and you’ll be ready to buy these new leaders when the stock market starts to advance again.

So here we are heading into September, historically a weak performance month for stock prices.  If history is a guide for the coming months, stock prices should decline in September and sometimes for a few weeks in October and then rise in the last two weeks of October through the end of the year.  It’s not a sure thing that this will happen.  So I watch and buy carefully, ready to sell if the decline continues into November and December.  Most importantly, you must maintain enough of your portfolio value so that you can participate in the next bull market.  “Enough” to me means having at least 80% of your portfolio value as the market bottoms out.

My purpose in putting these thoughts together is not to make you feel better about the current market decline and volatility.  It is meant to provide you with some understanding of how the market works.  Once you begin to understand what is going on, you (or your investment advisor) can devise an investment strategy to potentially profit from the current volatile decline in prices.  Warren Buffett is buying stock right now.  What does that tell you?

Note: Nothing contained in this article should be interpreted as a promise or guarantee of earnings or investment results nor a recommendation for the purchase or sale of any security or sector.

Dan Nestlerode was previously the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. He retired in 2015 after 50 years in the investment business. A graduate of Penn State University, Nestlerode became an investment advisor in 1965. He can be reached at [email protected]
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