Volatility: The New Market Norm
12/07/2010 9:11 am EST
Overall, market performance has been about average in 2010, but it was a tale of ups and downs, shocks and uproar. You may not like it, but you'd better get used to it.
Take the long view and look at 2010 as a whole now that we're near the year's end, and it looks just slightly better than average for the stock market. In 2010, in fact, investors earned a return that is clearly but not hugely above the stock market average over the last 60 years.
From 1950 through the end of December 2009, the Standard & Poor's 500 Stock Index returned 8.71% annually on average, once you include dividends and correct for inflation.
In 2010, from the close on December 31, 2009 through the close on December 3, 2010, the S&P 500 was up 9.86%. Add in a dividend yield of 1.98% for the year, then subtract consumer inflation of 1.2%, and you get a return for the year of 10.64%.
So it was an above average, but nothing to rave about business-as-usual year. Must have been profitable but about as exciting as watching paint dry, no?
Well, no. Not as we actually lived the year.
- From December 31, 2009, to February 8, 2010, the S&P 500 dropped 5.2%
- From February 8, 2010, to April 23, 2010, the S&P 500 gained 15.1%
- From April 23, 2010, to July 2, 2010, the S&P 500 dropped 15.9%
- From July 2, 2010, to December 3, 2010, the S&P 500 gained 19.8%
All told, 2010 has been—what shall I say?—volatile.
Why We're on a Roller Coaster
Any investor who hasn't retreated to a bunker until it's all over can recite the news items that have driven this stock market year.
- The Greek debt crisis and the solution to the Greek debt crisis
- The Chinese growth scare and fears over monetary tightening, and the relief when that fear of monetary tightening turned out to be less than expected and ineffective
- Optimism that the Great Recession was over, followed by fears that the United States would drop back into a double-dip recession, followed by relief that the economy was growing again—at any speed
- The Irish debt crisis (and the return of the Greek debt crisis), and the solution to the Irish debt crisis
You could stop your analysis of the stock market in 2010 right there. Stock prices were volatile because we had such volatile financial news (and I've left out things like the Federal Reserve's decision to dump $600 billion on global financial markets in a program of buying Treasurys, an effort known as quantitative easing and christened QE2, perhaps because it's so hard to steer).
But I think it's worth taking the explanation one step deeper and asking, "Why was 2010 so full of volatile financial news?" Ask that question, and we've got some hope of figuring out if 2011 will feel like another year of earthquakes or turn into a year of gentle zephyrs wafting through the flowers.
I'd argue investors should get ready for another year of volatility—because 2010 was just part of a wrenching process of adjustment in the global economy so large that there's no way it gets done in just a year.
Let me just run through a few of the changes that drove the volatility in 2010—and are likely to drive more volatility in 2011.|pagebreak|
Credit Where Credit Is Due
First, we're seeing a relative decline in the creditworthiness of the developed economies. From Japan to Italy to the United Kingdom to the United States (with a detour for Germany, perhaps), developed countries face such massive mountains of debt that it is by no means certain that they can ever repay the loans. (In fact, it is absolutely certain that the weaker among these developed economies will not be able to repay and will have to "restructure." Which is the polite word for default. Right now, the conventional wisdom is that countries don't go bankrupt—except that history is full of examples of countries doing just that.)
For the developed economies, we've just seen the start of a trend toward lower credit ratings, higher interest rates, slower growth, and weaker currencies.
On the other side of the seesaw, we're seeing a relative improvement in the creditworthiness of the developing economies. China sits on the largest foreign exchange reserves in the world, but we're also seeing investment-grade credit ratings going to countries such as Brazil, Indonesia, and Turkey for the first time. Just the other afternoon, I got news of credit upgrades for Bolivia and Paraguay.
For the developing economies, we've just seen the start of a trend toward higher credit ratings, lower interest rates, faster growth, and stronger currencies.
No investor should underestimate the extent of the effect of these changes. About a month ago, one of the folks who does trading for my Jubak Global Equity Fund (JUBAX) told me that friends of his back in Brazil were able to get 30-year home mortgages for the first time. Up until this year, inflation had been so high and interest rates so unpredictable that the 30-year mortgage, that bread-and-butter product of the US financial system, wasn't viable in Brazil.
The reverse is happening in developed economies. No, I don't mean that the 30-year mortgage is about to go away. But credit is getting tougher to get, and banks that need to either raise capital or cut back on the risk in their portfolios are choosing to cut back on risk.
New World for Investors
Second, we saw the beginning of a significant reordering of investor preferences for individual asset classes. But there isn't yet any great consensus on what assets to own.
For example, I think 2010 marked a last great bond rally, the one that puts a period to the long-running bond rally that started in the 1980’s when interest rates in the United States began their long, slow—and, if you were a bond investor, delightful—descent from June 1981 when the short-term Fed funds rate from the Federal Reserve hit 20%. We're now at what is effectively a 0% Fed funds rate.
It would be simple, if oh-so-painful, if rates headed straight up from here. Stocks would begin a steady descent, but volatility would go down. (Steady declines have nothing like the volatility we saw in 2010.)
But interest rates aren't going steadily up from here. Bill Gross, aka Mr. Bond, predicted just last week that the Federal Reserve won't raise interest rates for years. Instead, we're going to see battles in the financial markets among the investors, economists, and financial gurus who shout, "Inflation is around the corner! Beware!" and the skeptics who say, "Show me the inflation!"
When the first and loudest voices in the market warn of inflation, gold and other commodities will soar. Income investors will panic. The dollar will crumble. When those voices are routed, gold will tumble, income investors will weep at the low yields available to them but invest anyway, and the dollar will bounce. The long-term trend is indeed toward inflation and toward hard assets, but the trend will be one of mountains and chasms that make it hard for investors on either side to stay the course.
The Great Slowdown
Third, the United States has just begun what is likely to be a very slow recovery, one that will severely test a country that's accustomed to fast growth and that sees even relative decline as a failure of character. Citizens in European countries with the experience of years of lower economic growth than we're used to in the United States are familiar with the idea that quality of life isn't equivalent to the speed of growth of the gross domestic product.
There's a tradition of dialogue in countries such as Italy, France, and Sweden about the tradeoffs among growth and other values. The United States is just entering a period when some of its citizens, on the political left and right, whether environmentalist or religious conservative, are thinking about those tradeoffs.
Developing that dialogue to the point where every quarter of slower-than-the-fastest growth possible isn't automatically assumed to be the end of the world isn't going to happen overnight. While the dialogue is developing, the national discourse will swing to extremes of mood. (Well, maybe extremes that range from panic to "This isn't as bad as I expected.") Investors who live in a country subject to such extremes of mood will find it only too easy to overreact in their own investment decisions.
Don't You Be Volatile
Even if you're one of those iron-willed characters capable of holding to a disciplined course while all around you are losing their heads, it will be hard not to give in to volatility. We really don't know how fast the story will play out or even how the story will come out.
This year wasn't an aberration. We live in interesting times. And investors had better get used to it. (See my column "Ten Ways to Survive a Zombie Economy" and my post, "Volatility ahead in 2011—and how to live with it (and maybe even profit)" for some initial thoughts on how to cope with volatility.)
At the time of publication, Jim Jubak did not own shares of any of the companies mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), 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 here.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.