Watch out, higher volatility ahead. A jumpy market can cost you a chunk of cash even if the indexes don't plunge.

11/02/2009 12:47 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Hold onto your hats! I'm afraid that investors are in for a big step up in volatility.

Take Friday's 250-point drop in the Dow Jones Industrial Average.

Scary? You bet. But I’d argue that it was just “normal” volatility these days. It wasn’t the result of any significant change in fundamentals or global money flows.

  • Instead it was a “normal” sell off on a Friday after a big 200-point rally on Thursday—traders wanted to book profits from the rally and reduce positions going into the weekend.

  • Instead it was a “normal” sell off at the end of the October fiscal year for many mutual funds. It was time to book profits, to generate cash for distributions required by profits generated earlier in the year, and to dress up the books for end of the year reports.

  • Instead it was a “normal” sell off created by a U.S. dollar that after weeks of selling off had reached an oversold position and was ready for a bit of a rally as traders who were short the dollar bought dollars to close out some of their positions and to take some profits. A climbing dollar clobbered commodity prices, commodity stocks, and emerging market stock markets.


I don’t know whether Fridays sell off was a continuation of some kind of “mini” correction. The traditional definition of a correction is a 10% or so decline in stock prices. As of Friday’s close, the Standard & Poor’s 500 stock index was down just 5.6% from the October 19 high.

I don’t know if Monday’s rally—the Dow Jones Industrial Average is up about 100 points as I write this at noon—marks the end of that mini correction. Stocks have rallied on good earnings news from Ford (F)—the company reported its first operating profit since early 2008--and a better than expected report on manufacturing activity from the ISM survey of purchasing managers.

What the last week or so most likely signals, in my opinion, isn’t a clear shift in market direction but an increase in the market’s volatility. Up and down moves both are going to be more exaggerated for a while even as the market as a whole doesn’t go much of anywhere.

In other words we’re going to go sideways for a while. (Yes, I know “a while” isn’t terribly specific but it’s the best my crystal ball can do right now.) I still expect that this sideways period will resolve into another leg up.

“Sideways” isn’t as good as up if you’re invested in stocks. It sure beats "down," of course.

But it does come with its own dangers- especially if it’s sideways with enough volatility get emotions running.

The danger is that a choppy market will lead you into a frenzy of buying and sell as you try to keep up with its constantly changing moods.

Let’s take the action in the NASDAQ Composite index as an example. On Friday, after a bad week or so, the index approached a sell signal at 2040, according to technicians such as John Murphy and Arthur Hill of StockCharts.com. If the index closed at 2040 or lower, they wrote in a report to subscribers, it would trigger a “sell.” (I’m one. I think these guys publish some of the best technical analysis available to an individual investor at a reasonable price.)

The index closed at 2045 that day, but many traders began Monday November 2 glued to their terminals to see if the market would send a sell signal. The index did indeed hit 2036 at 9:45 a.m. that morning before rallying.

I don’t know where index will close. The 2036 at 9:45 may turn out to be a tease. The index could fall below 2040 at the close. It could rally today and then close below 2040 tomorrow.

This is exactly what happens in a choppy market with high volatility. Stocks generate lots of signals—technical or emotional—that can lead investors into selling and then buying and then selling and then buying. All the activity leaves a portfolio bleeding commissions and with significant trading losses since nobody ever gets the buying and selling perfect.

The last time that the NASDAQ Composite generated a sell signal back was back in July 2009, according to Murphy and Hill.

If you want to get through this period of volatility with as little damage as possible, you can learn a lesson or two from the market in that month.

Even if you had sold—with perfect foresight--at the July 1 market peak for the NASADAQ Composite at 1846, by July 15 the index had rebounded to 1863 and was on its way to the high of 2176 by October 19.

To have made your perfect call on the July peak work, you would have had to time a reentry into the market perfectly as well. Otherwise you would have perfected yourself from the losses of a minor dip and missed out on 3-months of rally.

All this supposes, of course, that what we’re going through now is a period of scary volatility that will with a resumption of the rally that will run into 2010.

I’ll look at why I believe that’s still the most likely course for the market later today.

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