Why market volatility signals a return to normalcy for investors

Investors have always had a love-hate relationship with stock market volatility. And what separates the group that welcomes a return to a more volatile environment from those that dread it is time horizon and preparation.

You see, investors with a short time horizon, or active traders, value the trading opportunities that accompany an increase in volatility. Daily price swings of 1%, 2%, or even 3% mean traders can sell stocks short in the morning, and then repurchase them and go long in the afternoon.

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Long-term investors, however, dread seeing the value of their multi-year investments swing around wildly without reason or cause. For many long-term investors, a return to a more volatile environment is a sign that the good times are over and it’s time to batten down the hatches for a period of portfolio pain.

Now, if the stock market volatility that erupted on Wall Street during the fourth quarter of 2018 is here to stay in 2019, and I believe it is for at least the next three to six months, the solution isn’t to bury your head in the sand and wish it away. Volatility, at least in the current context, represents both a return to investing normalcy and a period of extraordinary opportunity for the long-term investor that’s armed with a sound and reasonable investment plan.

Volatility triggers

The simple answer to what causes volatility is uncertainty. When investors are scared, nervous, or uncertain about future economic growth, a company’s profit forecast, or geopolitical stability they often respond by selling their investments.

Simply put, uncertainty triggers an emotional response among investors. And emotional investors are the root cause of stock market volatility.

Now, if you want specific events that the mainstream financial media will blame the increased stock market volatility on you can take your pick.

• Rising interest rates
• The end of quantitative easing and beginning of quantitative tightening
• Brexit
• The end of quantitative easing in Europe
• US-Chinese trade concerns
• A weakening US housing market
• Political fallout from the killing of journalist Jamal Khashoggi

Frankly, I could list 20 more things that are contributing to investors’ current uneasiness — but none of them matter. Because our goal shouldn’t be to identify potential volatility triggers; our focus should be on formulating a plan to deal with and profit from the increased volatility.

A reality check

When I began my trading career more than 20 years ago, a seasoned trader gave me a piece of advice that helped frame my view of the stock market. Here’s what he told me:

“Stock prices don’t move up or down, they move up and down.”

Those words, while logical and obvious, are lost on most investors. But in a nutshell, it means that the near constant advance in the stock market averages we saw from late 2016 through January 2018 isn’t typical.

In a typical market, stocks rotate higher and lower with periods of low volatility being followed by periods of elevated volatility. Historically, stock prices haven’t drifted higher for months at a time while day-to-day volatility plummets to all-time lows.

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Now, while the volatility that’s crept back into the stock market since mid- to late-October 2018 may be unsettling to some, let’s remember that not every 20% or more bear market morphs into a 2008-style financial collapse. Nor does a bear market guarantee that we will experience a recession.

However, thanks to the internet stock collapse of 2000 and the financial implosion of 2008, modern-day investors have been trained to believe that all bear markets are treacherous affairs that result in most stocks losing half to three-fourths of their value.

That’s NOT the case!

Between May and early October 2011, the Russell 2000 dipped nearly 30%. And again, from mid-June 2015 through mid-February 2016, the Russell 2000 lost approximately 25%. But neither bear market resulted in a crushing recession or banking implosion. And in both cases stocks stabilized and long-term investors that kept their emotions in check and were prepared to put money to work as conditioned improved profited handsomely.

The technical approach

Navigating an increasingly volatile stock market doesn’t need to be a heart-pounding task or exercise in futility. But to both survive and profit during an increasingly unstable environment one must understand and identify their investment time horizon.

For the long-term investor focused on building wealth throughout many months to several years, it makes sense to add to or initiate new investment positions into incremental price weakness.

Buying stocks after they’ve dipped 10% or 20% from recent highs, provided you understand the company and its prospects, is what separates the genuinely successful long-term investors from the emotional rollercoaster individuals that buy stocks at 52-week highs and sell them near lows.

A simple technical approach to understanding when stocks are positioned to rise or fall over the long term is to take a weekly candlestick chart and overlay a 50-week moving average on top.

As you can see on the chart above, dating back to 2015, when the iShares Russell 2000 ETF (NYSE:IWM) is trading above its 50-week moving average, dip-buyers are routinely paid to buy dips. But when prices are holding beneath the 50-week moving average, it’s often a sign that sellers are in control, demand is weak, and multi-week rallies are likely to reverse back toward recent lows.

Now, if you are exceptionally comfortable with the companies you’re investing in it may make sense to continue to buy while prices are falling beneath the 50-week moving average. But as a rule of thumb, limiting the amount of new investment while prices are under the 50-week moving is an easy way to avoid putting too much money to work in a bear market environment.

If your time horizon is measured in days or weeks, you have two choices.

If you’re comfortable selling stocks short, you can attempt to sell stocks on strength while they’re trading beneath their 50-week moving average, and then repurchasing them on weakness. And if you’re especially daring, you can attempt to buy stocks when they appear to be stabilizing near prior swing lows.

Alternatively, and a safer approach for the risk-averse trader, you can maintain a higher than usual cash balance and wait for prices to stabilize above the 50-week moving average before putting money to work.

The bottom line is investors will likely need to contend with an elevated level of stock market volatility for at least the next three to six months. Between the uncertain and volatile U.S-China trade war, rising interest rates, and, if Apple Inc’s (NASDAQ:AAPL) recent earnings warning is any indication, a deteriorating corporate profit environment, investors — especially those with long time horizons — must have a plan in place to weather the storm.

And implementing a technical approach like the one outlined above is a mechanical and straightforward way to remove emotion and bias from one’s investment decision process.

–At the time of publication, Byrne had no positions in the stocks mentioned

Story by ProactiveInvestors