Volatility ahead in 2011--and how to live with it (and maybe even profit)

11/23/2010 9:58 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

Last Friday, November 19, I sketched out a picture of a very volatile 2011 (http://jubakpicks.com/2010/11/19/5882/ ) and said that today I’d take my best shot at a strategy for how to invest through that turbulence.

I probably shouldn’t be telling you this, but most of the time investing is pretty simple: Follow the trend with your money and get your emotions out of the way. And that’s also the key to even a turbulent year like 2011 promises to be.

My strategy is based on taking advantage of that “most of the time” and staying alert for the exceptions.

Most markets are in a trend. Look it up yourself on a chart of something as staid as the Standard & Poor’s 500 Stock Index or something as supposedly volatile as the iShares MSCI Emerging Markets Index (EEM). If you graph just the daily moves of the market and the 200-day moving average, you’ll see that while the daily moves of the market create a mountain range of jagged peaks and valleys, a smoothing average, like the 200-day moving average, reveals a remarkably smooth and steady trend line.

So from March 2003 to December 2007 you’ll see the 200-day moving average draw in a very steady ascending slope. That’s despite big valleys on the daily chart like that in March 2007 and big peaks on the daily chart like that in July 2007.

Even though it tracks a very different set of markets than the S&P 500, you’ll see the same pattern in the Emerging Markets index. The ETF that tracks the index only goes back to 2003 but from May 2003 to June 2008 you’ll see a very steady upward trend in the 200-day-moving average. And that’s despite a big peak in May 2006 and a valley (well, more like a chasm) in June 2006.

If you play around with these charts, a couple of really important investing truths pop out at you.

First, the longer your holding period is, the less important the volatility on the daily chart is. Even the big peaks and valleys fade into insignificance when you’re looking at an upward trending 200-day moving average from March 2003 to December 2007 or from May 2003 to June 2008.

This observation can easily get extended into something like the extreme form of “buy and hold,” which argues that if you’re holding period is long enough, you should never sell stocks but just hold on through any volatility.

Second, it’s clear from looking at these charts that this extreme form of buy and hold isn’t really very good advice. And that’s because these “most of the time” trends are punctuated by bouts of volatility that are big enough to completely reverse the 200-day or any other other trend line.

The volatility from January 2008 through August 2009 (otherwise know as the Global Financial Crisis or the Bear Market of 2007) decisively ended that March 2003 to December 2007 upward trend. Same thing happened in the volatility of November 2000 to April 2003 (otherwise known as the Tech Bubble or the Bear Market of 2000).

Even if you draw a chart all the way back to 1950 you still see these great trend busting events. Some volatility is big enough to get your attention no matter how long your holding period.

Now apply these two observations to the year of volatility that I sketched out for 2011 and begin to turn them into an investment strategy.

  1. As scary as the volatility has been from, say November 8 through November 18, it really doesn’t matter much to you as an investor—as long as the trend that, in retrospect, began in July 2009 stays intact. (It took the rally that began in March 2009 until July to reverse the downward trend and establish a new upward trend.) In fact the volatility of the recent ten days hardly registers on even a three-month chart of the S&P 500.

  2. Second, as long as that upward trend in the 200-day moving average stays intact—and on November 19 the 200-day moving average was around 1125 and the S&P itself near 1200—then this volatility is either a trading opportunity (if your time frame is that of the short-term trader) or an opportunity to trim overweight positions (to sell partial positions) or to begin new positions or to add to existing positions (to buy, in other words) if your time frame is longer.

  3. The more predictable these periods of short-term volatility are, the better the opportunities they create. If an investor understands that a stronger dollar/weaker euro leads to a drop in the U.S. market, then that’s volatility that can be more easily exploited. If an investor understands that worry over tighter money supply in China and higher interest rates there leads to a drop in China’s stock markets, to a tumble in other emerging country stock markets and to a retreat in commodity and materials stocks in the U.S. market, then that’s volatility that can be more easily exploited. When you have something fairly concrete to track—the euro, Chinese monetary policies (or actually the rumors surrounding them) then you aren’t just left with immobilizing fear. (For an example of how this volatility isn’t inexplicable see my post  http://jubakpicks.com/2010/11/18/in-chinas-dip-its-domestic-consumer-stocks-1-and-overseas-export-stocks-0/ ) I would note that to exploit these opportunities, you do need to keep control of the size of positions you want to build in any particular stock. The point isn’t to wind up with a huge position in a company just because its shares keep getting killed in short-term dips.

  4. Volatility carried to an extreme can itself become a triggering event. It’s one thing to say, Oh, here’s an excess of fear over the Irish debt crisis that I can exploit because the odds are really good that the crisis will be over in a week or 10 days and the fear will recede within that time span. And it’s another thing entirely to look at Portugal spiraling into default, triggering huge 3% daily drops in the S&P 500 that send everybody screaming for the exits as fear begets more fear. (By the way, I’m not predicting a Portuguese default in 2011. I think any default anywhere is extremely unlikely in 2011. I think a restructuring of Greek or some other country’s debt in 2012 or 2013 when German and French politicians see that their voters can’t be moved to extend another pfennig or centime of credit. Take a look at the Irish crisis if you want to understand why no debtor nation will be left behind, yet http://jubakpicks.com/2010/11/15/the-euro-zone-gets-desperate-to-push-ireland-into-a-bailout-deal/ ) Not all volatility should be shrugged off.

  5. And all this holds true for 2011 only as long as the basic underlying long-term trend remains intact. That upward trend depends on three conditions, in my opinion: nothing really unexpected happens in the Euro Zone; China’s growth rate doesn’t dip below 8% with signs that it is still looking to go lower; and the U.S. economy doesn’t slip backwards from the current inadequate 2% growth rate.

To sum up this strategy for 2011:

Use volatility that you find predictable as your friend to increase profits (trading) and to control risk (buy low and sell high.)

Watch for signs that volatility hasn’t increased so much that it threatens to set off its own break in the trend.

Keep your eye on the stability of the underlying trend and the three factors that support it. Go with the trend as long as those conditions are met. And if they’re not, take steps to make sure your portfolio lives to invest another day.

That’s my rough outline of a strategy for investing in 2011.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of the most recent quarter see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/ )
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