STRATEGIES

Investors trying to cope with stocks' recent volatility are simply creating more ups and downs, so this trend will be with us for a while. Here's how to profit from it, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

And market volatility begat more market volatility.

That's not a quotation from some obscure piece of Scripture, but a description of how market volatility, over a long enough period, changes investor behavior to guarantee more volatility.

And if that's so, investors need to adapt their strategies and be prepared to handle the wild ups and downs. Call today's column my attempt at "Winning Strategies for the New Volatility."

How Wild Is It?
Think back to August of last year. From August 10 to August 15, the S&P 500 climbed 7.4%. And then from August 15 to August 19, the index gave almost all of that back, falling 7.1%. And then from August 19 to August 30, the index climbed 7.9%.

Be honest. Doesn't that history figure into your thinking about the rally/bounce/whatever that started on Thursday, July 26, and took the index up 3.6% in two days? Aren't you thinking about those 7% moves in four or five days in August 2011 and measuring the distance to the door (especially if you remember the bigger moves in 2011, such as the 16.3% tumble from July 6 to August 10)?

Doesn't that history make you think about sitting out the summer and coming back in October (especially since the S&P 500 gained 22.1% from October. 3 to October 26)?

And honestly now, don't you think about the fact that despite all this volatility, the stock market, as measured by the S&P 500 index close, was on Friday almost exactly (1,385.97) where it was on April 28 (1,360.48)?

Doesn't that make you want to do more trading, or sell winners sooner so you can buy them back cheaper in a week or month, or play momentum and forget all about fundamentals and long-term value? Doesn't it make you want to do something to take advantage of the volatility or to avoid getting hurt by it?

Of course it does. And it should. But recognize at the same time that those responses to volatility guarantee that the volatility will continue, and probably even increase. And recognize that it's not just the behavior and strategies of individual investors that feed the market's volatility. Institutional investors are reacting to the market's volatility with moves that increase that volatility.

For the five market days ended July 24, investors pulled $11.5 billion out of US equity funds, as they watched the Dow Jones Industrial Average fall by triple digits on three consecutive days. That's the biggest outflow in two years, according to cash-flow data from Lipper (which, by the way, reports based on market weeks ending on Tuesdays).

Much of that outflow came through exchange traded funds that track the S&P 500 and that are a favorite way for institutional investors to react to market volatility.

I wouldn't be at all surprised to read that in the five market days that end on Tuesday, July 31, money sloshed back into US equity funds in reaction to the big bounce on Thursday and Friday of last week.

A Trader's Market
Is this any way to run a stock market? What happened to buying stocks based on the fundamentals of the underlying business? Or being willing to look past the events of a week to the month or even the quarter? Or about holding for longer terms?

I don't think the current market volatility has repealed the wisdom of those approaches to making money on stocks. But this market sure isn't going to pay you for following those approaches. At least not in the short run, and perhaps (I fear in my more pessimistic moments) not even in the midterm.

A good part of this increase in volatility comes from real, global macroeconomic trends: As the world copes with the uncertainties caused by huge government debt, rapidly aging populations, global cash imbalances, and a very painful slowdown in growth in the developed world, it's only to be expected that financial markets will show the strain. And increased volatility is a result of that strain.

Even if you don't buy that logic, and you believe these extreme short-term moves are irrational, they can still cost you real money. No matter what you check off as the cause of this volatility, I don't think simply pretending that it doesn't exist is a viable strategy.

So what do you do?

Fighting the Trend
I don't think there's any one perfect strategy for coping with this volatility. Volatility in the current market comes in a wide variety of time spans. And if as I think, this volatility will be with us for a while, investors should mix and match strategies for that variety of time spans.

Let me give you some suggestions organized by the time span of the volatility from short to long.

  • Swing trading. Very short—days or a week or two.

In the current market, I think it's very possible to come up with a short list of stocks with very clear trading patterns that have very clear relationships to the ebb and flow of macro fears and hopes.

For example, Spanish bank stocks such as Banco Santander (SAN) and Banco Bilbao Vizcaya Argentaria (BBVA) sink when the financial markets seem convinced that Spain is about to ask for a Greek-style bailout. They soar when the financial markets seem convinced that someone—the European Central Bank's Mario Draghi, most recently—is about to ride to the rescue.

Both extremes are, well, extreme, and the likelihood is that Spain will neither go the way of Greece—the country does have viable industries, and Spanish exports have climbed with a sinking euro—nor be saved overnight through some financing scheme that prevents years of pain.

When fear was in the saddle in May, I was able to buy the New York-traded ADRs of Banco Santander, to use a specific example from my Dividend Income portfolio, at $5.77 and $5.35. Then, when hope headed higher, I sold those lots at $5.97 and $6.35 in June.

And then, what do you know? Fear gained the upper hand in July. I was able to rebuy those lots at $5.19 and $4.90, then sell them again in the Draghi bounce at $5.83 and $5.93.

Other swing-trade candidates that I've used lately are tied to fears of a hard landing in China. When that fear rises, Chinese stocks in particular and emerging-market stocks in general fall. When hopes that China will stimulate its economy rise, so do these stocks.

Some stocks I've been using in these trades include Cemex (CX), Gerdau (GGB), and China Eastern Airlines (CEA).

Tickers Mentioned: Tickers: SAN, BBVA, GGB, CX, CEA