Navigating Market Volatility with Confidence

Well that was fun! And by fun I mean white-knuckle bone crunching, jaw-scrunching face grimacing tastic! Caveat – I love a good old thrill- sky diving is my happy place. Quite amazingly, if one would have taken vacation for the whole of August, and not looked at the markets at all, then you would have come back business as usual, with the MSCI World (Equally weighted) index hitting a new all-time high right at the end of August. For the rest of us though, volatility returned to the market with a vengeance. But just how volatile did it get? Well, taking the VIX intraday high of 65 and a change at face value, it was the 3rd highest reading EVER: Gold medalist being the Global Financial Crises in 2009, Silver medalist the Coronavirus 2020 episode, and now Bronze medalist the ……. Well what exactly transpired on Monday 5th August that made markets fall out of bed??

But first, a quick reminder what the VIX is. The VIX is a real time index derived from the price of market options (typically S&P 500), generating a projection of short term volatility. Volatility, broadly speaking, is a measure of how fast prices change, and is seen as a way to gauge market sentiment, and in particular the degree of fear among market participants. The higher the VIX, the greater the level of fear and uncertainty in the market. Readings above 40 are historically relatively rare, so an eye raising 65 would presumably be associated with a catastrophic world event?

The answer without a shadow of a doubt, is a resounding no. People love to throw out a good old narrative in order to explain (or justify) market performance. Markets went up because XYZ happened. Markets went down because ABC transpired. Many narratives have been suggested to explain Monday’s market mayhem, including Japan raising rates leading to the unwinding of the carry trade*, worsening macro data, in particular the labor market, fears that the Fed are too far behind the curve leading to a policy error, increasing geopolitical tensions across the globe which all contributed to the overall fear and panic.

We will never be able to assign a narrative to explain the gyrations of the stock market, largely because short term market movements are highly dependent upon human emotion, which leads to irrational decision making, particularly during periods of extreme market stress. Indeed, this was a volatility eruption on par with a financial crises, and the S&P couldn’t even muster a 10% drawdown! And yet has already recovered all its losses. Japan was up more than 25% for the year by early July, before eradicating all its gains and then some during the August swoon, and has now recovered a significant portion of those gains.

?The only way to successfully navigate the shorter term market volatile gyrations is to have a long term mindset, which means having an long term asset allocation that is appropriate for your own personal liquidity needs and risk profile. You should have an allocation to equities that you are equally comfortable holding during both up (or bull) markets, as well as during the down (or bear) markets. And whilst the longer term is characterized by fundamentals, the shorter term is more highly affected by human emotions.

An additional advantage to having an asset allocation that is correctly aligned with your personal long-term circumstances, is that during times of fear and volatility, you are presented with an opportunity to deploy excess cash at more attractive prices. Over the long term, cash as a risk free asset, is pre-destined to lose out to Equity markets and other riskier assets. You are paid (hopefully appropriately) by your willingness to hold risk assets.

Cash is an appropriate asset class for funds that are needed, or likely to be needed over a defined relatively short period of time. There is a high level of comfort in having sufficient cash in the bank in order to fund obligations. However, there is de-minimis risk associated with cash. Without getting into political or conspiracy arguments, cash is always available, and acts as a store of value. As such, there is minimal volatility or drawdowns associated with cash, and accordingly, a limited level of return that one can expect from cash. It should not be thought of a long term investment per se, rather than a short term store of value.

Over the last 50 years or so, the S&P 500 has annualized at a pretty impressive 10.7%. The price you have to pay for that return, is a heightened volatility of about 15% annualized, and multiple drawdowns – in that 50 year time frame, 6 drawdowns that have been in excess of 30%, including a 50% drawdown. Cash on the other hand, has returned a mere 4.5% annualized, though with virtually no drawdown nor volatility.

The following analysis (performed in portfoliovisualizer.com) compares the performance of the S&P 500 versus cash since 1972, with a starting balance of $10,000 in each.

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Over the shorter term though, there are definitely periods when holding cash was beneficial to holding the Stock market. As can be seen from the rolling 36 month return for both S&P 500 and cash, there have been not insignificant periods where holding cash was the preferential strategy.

?For example, during 2022 when both the Equity market and Bond market both simultaneously crashed by about 20%, those sitting in cash would presumably have been feeling pretty good about themselves; however, if that cash was not deployed into riskier assets, over the long term, despite the additional volatility and drawdown, holding riskier assets has historically been proven to be far and away the preferential strategy.

?So if one has a mindset that is sufficiently long enough, one should be utilizing market volatility to their advantage, and buying in when others are fearful. Which is easier said than done. If you immediately deploy all excess cash into risky assets, and then the market turns southwards, you will no doubt be kicking yourself. On the other hand, if you delay purchasing, waiting for a market crash to occur before intending to buy in …. then you may end up not deploying at all. Market crashes do happen, but only periodically. And the longer you wait before deploying, the harder it is to actually pull the trigger when it does occur, as you are always fearful that a small decline will turn into a bigger decline, which will turn into a hubungous** decline. ?And hence you only deploy a smaller portion of what you actually should be deploying.

?A fair middle ground would be to dollar cost average into the market. Splitting up money that you would like to deploy into equal chunks, and deploying over a pre-determined equal time frame. Weekly, Monthly, Quarterly. Whatever your preference. Come what may. Whether the market is rising, or falling. Dollar Cost Averaging makes it easier to stomach deploying into rising markets, or allows you to purchase at better pricing in a falling market. And if you’ve been meticulously following a plan, and market does take a turn for the worse, you always have the ability to get a little more tactical and use volatility to your benefit and ramp up your deployment plan. All this of course is predicated upon the assumption that your portfolio is appropriately aligned with your personal risk profile.

This is not a recommendation to simply buy at all costs, or even a view on the market. This is a reminder to utilize market volatility and drawdowns as an opportunity to deploy excess cash that is earmarked to be invested anyway at lower prices.

?*The carry trade is a strategy where an investor borrows capital at a low interest rate to invest in assets with potentially a higher return. The Yen was a popular carry trade, as the Japanese interest rate was so low. Investors used to borrow in Yen and invest in assets of higher yielding currencies. The unexpected increase by the Bank of Japan and the rapid appreciation of the Yen put a swift end to the popular trade, with investments based on this strategy unwinding abruptly, putting pressure on markets.

** I don’t think hubungous is an actual word. I just think it has a wonderful ring to it.

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Dani Schijveschuurder is an investment advisor that provides advice regarding the financial vehicles mentioned in the article. The views and opinions of the writer are his own and do not represent the views or opinions of the Goldrock Partners or its affiliates.