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Why Stock Markets Are So Volatile

The volatility in stock markets is one of the principle reasons why private investors sell out at the wrong time and often fail to benefit from the natural appreciation in stock markets over time.

If you are to save and invest through the stock markets you must accept that volatility in markets is normal, and an understanding of why markets tend to be so volatile can alleviate many of the fears that you might experience when markets enter a volatile phase.

After all, volatility is not the same thing as risk, and if you succumb to volatility by selling out under pressure you may take a permanent loss when all you were experiencing was a temporary decline in values.

The principle causes of volatility are;

  1. The economy is volatile and experiences periods of contraction as well as expansion.
     
  2. A contraction in the economy leads to lower revenues for businesses, and with fixed overheads this, in turn, amplifies the reduction in corporate earnings.
     
  3. Furthermore, stock markets are emotional and over-react relative to the likely change in these underlying business fundamentals.

The following table illustrates the second point well. It highlights the last four recessions in the US economy as depicted by a decline in GDP growth.

US GDP & Corporate Earnings

The US experienced recessions in 1981/82, 1990/91, 2001 and again in 2008/09. The table highlights that the decline in corporate earnings was substantially higher than the decline in economic output. A decline in earnings understandably leads to a decline in share prices. Indeed, share prices will lead the decline as investors try to anticipate the downturn.

But earnings have always recovered, and the following chart depicts the growth in earnings at the 500 companies making up the S&P 500 Index since 1969. After each downturn (highlighted with red arrows), earnings recovered fully and went on to new peaks. Over the 43-year period from 1969 to 2012, earnings of the S&P 500 companies grew at 5.7% compound per annum.

S&P 500 - EPS (1969-2012)

Markets are liquid and emotional and while investors generally anticipate a contraction in corporate earnings, they typically over-react to it. Indeed, often investors anticipate a decline in corporate earnings when none actually occurs.

The next table highlights the four occasions since 1987 when the US stock market declined by 7% or more when there was no subsequent decline in corporate earnings. The infamous 1987 stock market crash is noteworthy, as the market decline of 33% from peak to trough from August to November 1987 occured at a time when corporate earnings growth remained robust. Equally, in 2010, investors feared another recession and the US stock market declined 13% from peak to trough yet no subsequent recession or decline in corporate earnings took place.

S&P 500 and Corporate Earnings

What's the Moral of the Story
Stock markets in the developed world have delivered the best returns over the long-term (some 4% per annum over bank deposit returns), but if you are going to benefit from those superior returns then you had better have an investment plan that can handle the volatility. This means planning for volatility at the outset.

A Plan That Avoids the 3 Principle Risks
As I said at the outset, volatility is not the same thing as risk and mistaking volatility for risk can lead you to take a permanent loss rather than recognising the decline as likely a temporary one.

Of course, if your approach to selecting stocks or funds is not robust then you may well be taking unnecessary risks, and this can lead to permanent losses. Stock market volatility will ruthlessly uncover poor stock and fund choices.

The Three Major Risks
Risk is buying poor quality businesses (examples in Ireland in recent years included Waterford Wedgwood or Independent Newspapers). Risk is taking on too much debt either by you personally or by the company you own (the banks everywhere were guilty of this and most of them went bust). Risk is overpaying for an asset to the extent that it compromises your ability to earn a return. I recently gave the example of Coca Cola, whose share price today remains below the level it reached in late 1998. Coca Cola shares were so overvalued in late 1998 that even though their earnings have tripled since then they still have not provided a return other than the dividend income since.

Simple Plans to Lower or Eliminate Risks
Buying good quality companies at fair values, which avoid excessive use of debt and diversifying is a great way to lower risks in markets. Of course, if you are not an experienced investor then investing in funds can solve a lot of problems.

When you get comfortable with the fact that volatility is not actually the enemy then you realise that volatility is there to be taken advantage of; by buying shares or funds you are confident in when they are on offer at good values.

GillenMarkets.com - How We Can Assist
Gillenmarkets exists to assist private investors to navigate the markets. We provide an understanding of why markets are doing what they are doing, and we seek out good quality stocks and funds and provide coverage of them for subscribers. We believe it is akin to having your own personal fund manager.

As I highlighted in the last Featured Article, our Regular Investor slot continues to do a decent job of investing in such stocks and funds, and any subscriber can just follow the buys (and sells) outlined while they are learning and gaining confidence.

An annual subscription to our website costs €199. After gaining access to the 'members area' via the free trial we believe you will recognise the value proposition the annual subscription offers.

We also provide training for those who wish to kick start or speed up their knowledge of investing. Our 1-day training seminars have been going since 2005, and our next seminar is on in May - email to info@gillenmarkets.com if you wish to register or to get details of the day and costs.

If you are curious, but not sure, then you can avail of our 14-day free trial to the website, which gives you access to the whole website for two weeks, and to two weekly bulletins from myself - published on a Saturday. You will also get access to the Global Investment Strategies and their current selections. 

You will have to enter your contact and credit or debit card details to avail of the free offer, but you can opt out before the free trial is up, and before anything is charged.

These Free Featured Articles are part of our marketing. We hope you enjoy them, but we also hope that at some stage you'll consider joining our growing list of subscribers.

Until the next Featured Article...which will touch on what we mean by the phrase 'long-term' in investing, and you'll see that the definition of 'long-term' is different depending on whether you are a lump-sum investor or the person who can invest over time.

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