Searching for Meaning in Bouncy Times

After four-plus months of bouncy markets and overall flattish returns, it seems pundits have finally found the volatility’s cause: The market is shifting! From what to what, you ask? Good question. Some say it’s correction time. Others say leadership is shifting from so-called momentum stocks to high dividend payers. One corner says portfolio positioning and valuations, not fundamentals, are driving returns now. And some say we’ve reached the phase where stocks have lost steam and need a catalyst to keep rising (like maybe M&A). We could write an entire article on why any and every one of these theories misses the mark—you can’t predict corrections, momentum isn’t an asset class, fund flows don’t drive performance and stocks have long since proven they can rise without phenomenal economic or earnings growth. But there is a larger fallacy underpinning them all: The notion that volatility has to mean an inflection point of some sort. In apparent desperation to find meaning in these gyrations, the punditry seems to have forgotten a key point: Market volatility is normal.

It’s easy to see why they’re overlooking that simple truth. It’s a bit, well, boring. It might have flown in the days when US media consisted of three networks, a few national newspapers (in addition to your local rag) and a couple major financial publications. Then, it was far easier to get eyeballs. Now, it’s harder. We have multiple 24/7 cable news channels catering to the left, right and everything between—including state-run Russian—hundreds of websites, and an entire blogosphere competing for ratings and clicks (and ads). Boring, historically grounded explanations for market trends just don’t attract attention—hype and hyperbole sells.

The rise of cable and the Internet has its benefits—investors have access to more information than ever before. But it also has its drawbacks, like the sheer volume of noise. When markets are volatile, talking heads get louder. It’s not all the media’s fault, though. As humans, we’re both extraordinarily bad at scaling volatility (Exhibit A: The many characterizations of the market’s roughly 5% trading range as extraordinarily volatile) and desperate to find meaning in every market blip. Understanding why markets are volatile helps us feel more comfortable with it. As does having an actionable takeaway. The media is simply giving us what we want.

Problem is, this can lead to some very short-sighted, inadvisable portfolio moves. History shows stretches like the past four months are normal during bull markets. Sometimes these stretches precede corrections, sometimes they don’t. Sometimes they’re accompanied by leadership transitions, sometimes they aren’t. Volatility isn’t inherently a turning point—just because headlines shout “Inflection!” with extra inflection doesn’t make it true. Pardon the tautology, but volatility is simply volatility. However, when headlines scream the opposite, it’s tempting to follow their advice.

Today, following the headlines’ advice could mean getting out of stocks entirely—why sit through that potential 10% to 20% drop if charts and patterns give you a good warning sign? (Especially during May! And in a midterm election year!) Never mind that charts and patterns are all based on past performance, which every investor knows intuitively (and every disclaimer and fund prospectus says) doesn’t dictate future returns. And never mind that no guru ever, as far as we’ve seen, has accurately and repeatedly predicted the beginning or end of a correction. And never mind the opportunity cost of getting out in anticipation of a correction that never comes—transaction costs plus missed upside hurts.

Or, you might stay in stocks but concentrate in high dividend payers. This is just heat chasing dressed up as a safety play—headlines say formerly high-flying growth stocks won’t fly anymore, and cash payouts are the only way to make money in this sideways market. One, it ignores the flaws with a dividend-focused strategy (dividends aren’t set in stone, they’re often cut, and dividends are only one component of total return). Two, it’s all based, again, on performance over a very short period—dividend payers have outperformed non-dividend payers over the past two months. Hot dog. This bull has many instances of narrow categories outperforming over short bursts but lagging over longer periods. Utilities outperformed from mid-April through August 2010 and August through September 2011—but have lagged badly this entire bull. Financials outperformed for the bull’s first six months, then lagged for over two and a half years. We could easily go on, but you get the drift: What’s hot doesn’t always stay that way, and it takes more than price movement to determine whether fundamental shift is afoot.

So how should investors see the volatility and its accompanying noise? In our view, as the same old normal wobbles and static that feature ad infinitum during bull markets. This is when focus and discipline are key. Yes, there are times when it makes sense to make tactical changes. If fundamentals suggest different sectors should do better over the next 12 to 18 months, that’s something you can game. Ditto if conditions indicate a bear market is forming. But these judgments require being forward-looking—and frequently arriving at a conclusion that’s out of step with the mainstream. If you see a raft of headlines urging you to do something based on recent past performance, chances are they aren’t applying the wisdom and discernment necessary to make these calls correctly.

At the risk of sounding like a broken record, our advice today isn’t different than it has been throughout this bull market: Tune out the noise, focus on where stocks are likeliest to go over the next 12 to 18 months, and remember your long-term goals. This bull market should keep rewarding patient long-term growth-oriented investors for the foreseeable future.