Volatility is here to stay and you shouldn't simply ignore it and hope that it will go away: here are four investing strategies for coping (maybe even profiting) with it

07/31/2012 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

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 of time, changes investor behavior to guarantee more volatility.

And if that’s so, investors need to adept their strategies to this heightened volatility. Call toay’s post my attempt at Strategies for the New Volatility.

Think back a year to last August. From August 10 to August 15 the Standard & Poor’s 500 climbed up 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. Like 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? Remember that the S&P 500 rallied by 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 measured by the S&P 500 index was at the close on Friday, July 27, almost exactly—at 1385.97—where it was on April 28—at 1360.48?

Doesn’t that make you want to do more trading, or sell winners sooner so you can re-buy them 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 are feeding into the market’s volatility. Institutional investors are reacting to the market’s volatility with moves that increase that volatility. For the week ended July 24, investors pulled $11.5 billion out of U.S. equity funds—after the Dow Jones Industrial Average fell by triple-digits on three consecutive days. That’s the biggest outflow in two years, according to cash flow data from Lipper. And much of that outflow came through ETFs (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 week that ends on Tuesday, July 31, money sloshed back into U.S. equity funds in reaction to the big bounce on Thursday and Friday of last week.

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 through the events of a week or month or even quarter? Or about holding for the long term?

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 mid-term. 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?

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, volatility is 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 small list of stocks with very clear trading patterns with 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 (BBVA) sink when the financial markets seem convinced that Spain is about to ask for a Greek-style bailout and they soar when the financial markets seem convinced that someone—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 http://jubakpicks.com/, at $5.77 and $5.35 and 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 again in July and I was able to rebuy those lots at $5.19 and $4.90 and then sell them again in the Mario 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.) Caveats include watching transaction costs and time of execution—I’ve found that for the shortest of these overseas trades ADRs work better than locally traded shares--and keeping a constant watch for the break down of trading patterns. I haven’t used Gerdau in a swing trade lately, for example, because the Brazilian market has developed its own problems—related to the domestic economy in Brazil—that makes the trading range of Gerdau less reliable. Dangers include, besides getting it wrong, losing out on the gains of a stock that keeps on climbing after hitting what was once the top of its trading range. At the moment, CEMEX looks like an example of that.

  • Sector trading. Medium term—a matter of a month or two—perhaps more. Gold is a good example. With the euro falling and the U.S. dollar rising gold has been an unloved asset. Inflation didn’t look like a danger with European economies dragging down the global economy and with the dollar rising the dollar-denominated value of gold fell. The shares of a gold miner such as Goldcorp (GG), a member of my Jubak’s Picks portfolio http://jubakpicks.com/ had rallied in the early part of the year—January through March—when investors believed that the 1.3 trillion euro loan facility that the European Central Bank had put together for European banks would make a lasting difference in the euro debt crisis (and expand the money supply.) But the shares, along with the shares of most gold miners and with the price of gold itself, then fell and fell as investors came to believe that this lending facility was just another patch rather than a solution. But recently as the odds of more stimulus from the European Central Bank and another round of quantitative easing have increased, gold stocks and gold itself have rallied. Shares of Goldcorp, for example, have been one of the biggest winners in the Draghi bounce rising almost 10% from the close on July 24 to the close on July 27. Other commodity sectors, copper, for example, are worth considering as ways to take advantage of medium term volatility. So too are the safest of safe dividend paying blue chips, which will turn into attractive safe havens in the next swing to fear. As with swing trading, for sector trading to turn a profit for you, you have to be willing to buy when these sectors are out of favor. You want to buy Goldcorp at $32 when everybody hates it in early July and not now at $36. Caveats include a need for more patience since sector trades take longer to turn around and can try your convictions. (This is one reason that you should consider dividend-paying stocks to use in these sector trades such as Freeport McMoRan Copper & Gold (FCX) with its 3.7% dividend yield. This stock is another member of my Jubak’s Picks portfolio http://jubakpicks.com/ ) Dangers include just getting the sector trade wrong when sector fundamentals change (as happened to me with recently sold Jubak’s Picks http://jubakpicks.com/ member Potash of Saskatchewan (POT) or buying the wrong horse in the sector.

  • Seasonal trades. Medium term but longer—six months or so. Remember buy in November and go away in May? That pattern has been a winner back to the 1950s, according to the Stock Trader’s Almanac, but last year’s huge year-end rally that started in October and then petered out in April created a legion of new believers. (It didn’t hurt that the rally of 2011 peaked at the end of April, of course.) I think that a lot of investors have decided to sit out the summer in 2012—I know I’m not rushing to put the big cash position in Jubak’s Picks to work during the summer months—and are looking forward to a rally in the fall. Of course, widely expected rallies can fail to materialize because everybody expects them. But they’re just as likely to become self-fulfilling prophecies—at least initially—as everybody takes positions, driving up stock prices, in preparation for the expected rally. This strategy looks to sit out a weak August and September and to start to buy depressed high quality stocks in October. Some stocks to look at would include Coach (COH), Cummins (CMI), and Apple (AAPL)—although the timing for Apple has more to do with the next iPhone than general seasonal factors. Dangers include macroeconomic scares that could derail this seasonal pattern—the U.S. fiscal cliff comes to mind.

  • Contrarian trades. Okay, this may not be the easiest time to be a long-term investor but that doesn’t mean you should give up on the strategy. In fact the volatility in the current market will give investors with genuinely long time horizons—five years or more—a chance to buy cheap. I can give you a list of places to look. I’d be looking at oil companies with big stakes in new frontier geologies of Southeast Asia, East Africa and the West African-South American belt such as London-traded BG Group (BG.LN), Toronto-traded Pacific Rubiales (PRE.CN) and New York-traded Talisman Energy (TLM). Another choice is shares of cash-rich Japanese companies in the consumer sector as long as they have a big presence outside of Japan. My favorite stock in that category is Tokyo-traded Seven & I 3382.JP), the owner of the global 7/11 convenience store brand. Japanese stocks are now trading at a near-20-year low valuation. And while I understand the worry about the Japanese economy, Japanese government debt, and Japanese demographics, global Japanese consumer companies aren’t doomed by those problems. Caveats include a call for lots and lots of patience while you wait. (Here again dividends help: Seven & I pays 2.8% for example.) Dangers include being so early that the eventual profit doesn't represent a very attractive annualized rate of return. I’d combat that problem by averaging in on the worst dips—such as now—and putting buying on hold during rallies.

This isn’t an exhaustive list of either time frames or attractive opportunities within those time frames. Even so it may strike you as exhausting. After all, it’s hard enough to pursue one strategy successfully, let alone 2 or 3.

You don’t need to have a position in each of these camps, however. Nor do you need to work equally hard at each strategy. Maybe one or two swing trades will do for you while you work on a go away in May strategy.

My main point isn’t that you have to do one or the other or all of these strategies. I do think, however, that you need to spend some thought on the possibility—the likelihood to my way of thinking—that the current market volatility will be with us for a while and that we all need to figure out how to cope with it.

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 http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Apple, Banco Bilbao Vizcaya, Banco Santander, BG Group, Freeport McMoRan Copper & Gold, Gerdau, Goldcorp, Pacific Rubiales, Seven & I, and Talisman Energy as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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