Iron Capital Insights

  • Iron Capital Insights
  • April 24, 2013
  • Chuck Osborne

Is Volatility Back?

For years I have been giving the same talk about the standard measures of risk used in the modern financial world: standard deviation and beta. Standard deviation is a measure of absolute volatility, while beta is a measure of relative volatility. Standard deviation measures the average, or “standard,” difference, or “deviation” (we financial types are really creative with our terminology) between actual returns and the long-term average returns. Beta is the difference between an investment’s return and the market return over time. For those eighth grade geometry students out there, beta is the slope of the line representing the relationship between a particular investment and the market as a whole. After explaining this I make sure everyone is awake by telling the same joke I have told for more than 20 years now: The problem with standard deviation and beta is that they measure volatility, and volatility goes in both directions. No client has ever complained about upside volatility.

It is funny, relatively speaking, because it is true. Last week the market, as defined by the S&P 500 index, was down more than 2 percent; they call that volatility. That downward move has been almost erased in two days; they call that a rally. The truth is that both moves are examples of increased volatility, and both understate what is occurring underneath the surface. The intra-day moves on some stocks have just gone nuts recently. Mining company Cliff Natural Resources has seen four percent swings on two of the last three trading days, and Apple dropped almost five percent on rumors last week. Holly Frontier, the oil refiner, has had a full correction – down ten percent and then a full recovery in a matter of four or five business days.

What does all of this mean? It means this market is becoming more fragile. It is as if everyone knows that there must be a correction looming, so any bad news sends individual companies down quickly. But everyone also knows that stocks seem to be the most attractive place for the long term, so any correction is likely to be followed by a rally, and no one wants to miss the rally.

In the meantime, while the market is hyperactive, nothing has really changed in the real world. We are back to the same old broken record: The economy is slugging along at a two percent pace and the economic forecasts continue to swing wildly around that seeming constant. Recently we swing from over-confidence in forecasts, with some economists recently projecting as much as three and a half percent growth, and right back to reality. Soon maybe we will be getting the warnings of another recession. Meanwhile the economy itself just slowly chugs along, ignoring all the wild predictions.

While I was writing this the market dropped one percent and immediately rebounded on a rumor from a false tweet about an attack on the White House. Is volatility back? It appears to be, and that is not all bad. Long-term investors can often take advantage of the hyper over-reactions of the market. Should a correction finally take hold that is what we would recommend.

Chuck Osborne, CFA
Managing Director