Choppy Trading Frays Nerves
Despite extreme volatility the averages have avoided a breakdown below the August lows. A move below those lows — 10,719.94 on the Dow Industrials and 4,221.60 on the Dow Transports — would reconfirm the bearish primary trend. A rebound above the respective August highs of 11,613.53 and 4,683.96 would be bullish. For now, as a partial hedge, about one-fourth of our buy lists are in a short-term bond fund.
Coping with volatility
The Dow Industrials have gained or lost at least 1% on 49% of the trading days since July 1, up from 18% of trading days in the first half of 2011 and 27% in 2010.
Volatility is also up on a longer-term basis. Since January 2000, the S&P 500 Index has experienced intraday fluctuations of at least 4% at nearly six times the rate seen in the four decades through 1999, according to a study by The New York Times. Ten of the 20 biggest daily advances since January 1980 (and 11 of the 20 largest daily declines) have occurred in the last three years, according to professor Andrew Lo of M.I.T.
Some blame the volatility on computerized trading and the hundreds of billions of dollars that have flowed into exchange-traded funds over the past decade. Others say stock prices are moving faster because news and security-price changes are disseminated more quickly nowadays, while others rightly point to the uncertain prospects of the global economy.
Whatever the reason, you need to be prepared for short-term volatility if you want to earn attractive long-term returns in the stock market. Here is what we suggest:
• Don't assume there is an explanation for every big move. Because of the way our brains are wired, we tend to feel better when we think we know the cause behind an effect. Knowing this, reporters and analysts are usually more than willing to attribute market action to a specific news development. Sometimes these explanations are valid, but there is not a big story behind every big move. So, keep an open mind and be skeptical of anybody who tells you exactly why a stock or the stock market moved.
• Don't make things worse by fixating on your purchase prices. Researchers say the anguish we experience due to a loss is felt about twice as acutely as the pleasure we get because of a gain. Volatile markets make it more likely that you will suffer anguish because of short-term losses. But if you think a stock is going to be substantially higher in 12 to 48 months, you should not let the potential for short-term pain dissuade you from buying. Once you make a purchase, focus on whether a stock still represents one of your best ideas — not on whether it is up or down from your purchase price.
• Anticipate how you will react to volatility. If another 10% to 20% drop is going to put you over the edge and force you to sell, you should probably not be in stocks. Set your stock-market exposure at a level that allows you to ride through ups and downs without panicking.
• When using the Dow Theory, realize that market moves tend to be more compressed nowadays. To avoid being whipsawed by short-term zigs and zags, Dow Theorists assume the primary trend is unchanged unless both the Industrials and Transports move to significant highs or lows. These highs and lows mark the end points of significant secondary moves (corrections in bull markets and rallies in bear markets). As a rough guideline, Dow Theorists have defined significant moves as those that retrace at least one-third to two-thirds of the preceding move over three weeks to three months.
While it still makes sense to look for one-third to two-thirds retracements, insisting that significant moves endure at least three weeks can be problematic in today's fast-moving markets. Partly for that reason, we're inclined to view the August highs of 11,613.53 and 4,683.96 as significant, even though the Transports' rebound from Aug. 19 to Aug. 30 encompassed only seven trading days. A move above the August highs is likely to trigger a boost to our stock-market exposure.