Phase Dance

by Brian Pretti CFA, Contrary Investor. April 25, 2008

Maybe it’s always this way, but it sure seems 1Q earnings season, and the expectations of earnings releases in many cases, has brought us a very decent amount of individual stock volatility in the last few weeks. Watching the likes of a Google vault 20% due really to favorable foreign currency translation, or a Citi pick up a bit of steam based on a "kitchen sink" type of quarter (as you know, it’s probably the third "kitchen sink" quarter in a row now, but who's counting?), have been quite the sights to behold. And as always, if these types of individual stock acceleration motivators aren't enough, there's always the old standby "they beat expectations" to fall back on. Amazing this one still works after all of these years, isn't it?

Anyway, now that the Fed and friends have made it absolutely clear they will backstop the financial sector, we're in a period of relief. Relief that the end of the world as we know it, so to speak, is not about to occur in real time. The relief phase of the current equity cycle journey is upon us. But what about the next phase? Looking ahead, investors will ultimately have to discount the character and complexion of the domestic US economy, continued economic strength or weakness abroad, and what this all means for individual equity sector earnings prospects looking forward. Certainly a key piece of this analysis and ultimate discounting rests with the character of the US consumer. One step at a time as we move forward. The current phase of relief will ultimately give way to the phase of reality in corporate earnings strength as we move toward summer. In my mind, this is the next important phase that awaits us directly on the road ahead.

But having said all of this, sector and individual equity volatility of the moment can be quite the test of the old human nervous system day to day, especially for those needing to remain in harmony with short-term performance mandates. And that's a lot of folks. Watching major equity averages pole vault 2% in one session theoretically based on a handful of company earnings releases can leave certain investors wondering if anyone got the license plate of the bull that stampeded them. I think sometimes it helps to take a step back and look at the history of the type of daily volatility we have experienced as of late. And without further adieu, that's exactly what I what to do over the remainder of this discussion.

First, the rather lengthy table below recounts all of the one day 2% or greater price gains in the S&P 500 going back to the beginning of 2001. This is exactly the type of volatility phenomenon we experienced last week, and have experienced on six days so far this year. Why go through this exercise? As you'll see, I believe it tells perhaps a very powerful story about the bigger picture of life. A picture we can often lose sight of watching the blinking red and green lights on the screen each and every second, and counting the daily chips we either gather from the equity market table or leave for the financial market dealer of life to collect from us. Have a look.

2001		2003
Jan 3	5.01%	Jan 6	2.25%
Mar 27	2.56	Feb 14	2.14
May 10	2.71	Mar 13	3.45
May 16	2.84	Mar 17	3.54
July 12	2.37	Mar 21	2.30
Sept 24	3.90	Apr 2	2.61
Sept 28	2.19	Apr 22	2.17
Oct 10	2.29	June 16	2.24
Nov 1	2.29	Oct 1	2.23
Dec 5	2.23	2004
2002		2004
Mar 3	2.26	None
Apr 16	2.34	2005
May 1	3.75	None
May 14	2.11	2006
June 17	2.87	June 15	2.10
July 5	3.67	June 29	2.16
July 29	5.41	2007
Aug 6	2.99	Aug 6	2.42
Aug 7	2.00	Aug 17	2.46
Aug 8	3.27	Aug 29	2.19
Aug 14	4.00	Sept 18	2.92
Aug 19	2.36	Nov 13	2.91
Sept 25	2.49	Nov 28	2.86
Oct 1	4.00	2008
Oct 10	3.50	Jan 23	2.14
Oct 11	3.91	Mar 11	3.71
Oct 15	4.73	Mar 18	4.24
Oct 17	2.23	Mar 20	2.39
Nov 14	2.46	Apr 1	3.59
Nov 22	2.14	Apr 16	2.27
Nov 27	2.80
Dec 16	2.35

Isn't that something? These 2% one day up moves are far from uncommon. In fact, quite the opposite. But as you've probably already guessed, it’s when they occur that is perhaps the key to the bigger picture.

We sure as heck saw a lot of 2% one day S&P price advances in 2001 and 2002. Early 2003 was no slouch either. But then the equity markets in latter 2003, and throughout virtually the entirety of 2004, 2005 and 2006 went into a period of literal daily volatility dormancy. What a minute, where was the fun in the 2003-2006 period? Why the sleepiness? Had all the day traders and faster money speculative "investors" gone on holiday? Had Cramer stopped earning his CNBC paycheck by espousing actual long term investing (longer than a day or two) over this period? God forbid that ever happen, right? Well thank heavens that more regular occurrence of 2% one day up moves in price of the good old SPX began again in earnest starting last summer. That's certainly a relief after such a long dry spell for the Fast Money panelists on the epitome of financial journalism network. Boy, now things can get back to normal in terms of making money in stocks, no?As always, at least in my mind, very often pictures speak much louder than words, even if they are spoken in the name of true and unmitigated sarcasm. Rather than pondering the lengthy table of numbers above, just look at the market periods in the chart below where we have experienced the big time 2% up days in the wonderful SPX in relatively rapid fire fashion, and the period where the fast money boys and girls were apparently taking a well deserved siesta.

All kidding aside, recent history tells us periods of frequent and impressive daily equity market upside volatility are to be feared, not embraced. You've probably heard the common wisdom about being fully invested at all points in time. It goes something like, if you missed the best ten days of the year, you missed "X" percent of total performance for the year. You know what I'm talking about. Well, let me flip this on its head just a bit.

In 2001, we experienced ten days (shown in the table) where the S&P gained over 2% for the day. Collectively, these ten days produced a price only return of 28.4%. Too bad for the total year 2001, the S&P lost 13% in price point to point. Wildly, in 2002, the twenty-two days of above 2% one-day gains I showed you in the table above produced a collective price gain of 67.6%. Wow!!! A blow away. Quite the shame that point to point, 2002 saw a 23.4% price loss for the S&P. Not even the incredible one day upside volatility experiences of that year could even dent the meaningful buy and hold downside performance for the entire year.

The message is clear. Dramatic daily upside equity index price volatility decade to date has occurred during some of the most difficult broader periods for equity market behavior, and vice versa. This is the important message. Dramatice daily upside price volatility is a character warning. Slow and steady wins the race? Kinda looks that way, doesn't it? Don't tell the folks on CNBC, okay? We don't want any blow-dried commentators questioning their personal reason for being that is daily volatility cheerleading.

Brian Pretti

Contact Information

Brian Pretti CFA | Editor and Publisher, Contrary Investor
P. O. Box 4402 | Walnut Creek, CA 94596 | Observations | E-mail