Is The Increase In Volatility Signaling A Dangerous Market Environment?

Introduction

Over the last several weeks stock price volatility has increased significantly above norms.  All of a sudden it is not uncommon to see stock prices moving 5%, 10% or more in a single trading day. Interestingly, this volatility is occurring both to the upside and the downside.

Common sense would suggest that the intrinsic value of a business cannot change by those orders of magnitude from one day to the next. Logic dictates that the market is either inaccurately pricing the stocks now or it was incorrectly pricing them yesterday.

Stock price volatility is an unavoidable and undeniable reality.  The stock market is an auction, and as a result, prices are continuously fluctuating both up and down. Of course, that is stating the obvious, because every investor in common stocks surely understands the associated daily volatility. However, my experience in talking with investors suggests that not every common stockholder embraces the complete unpredictability of stock price movements in the short run.

However, once you accept the undeniable reality that it is impossible to predict where the price of a stock will go in the short run other than by chance, your perspectives on investing in stocks changes dramatically. For starters, you quit attempting to worry about the unpredictable and are inclined to focus on matters that are more reliable. When investing in businesses (stocks) you begin to understand that business fundamentals are more predictable and trustworthy than attempting to guess price action.

The venerable mutual fund manager Martin J Whitman put it quite succinctly as follows:

“I remain impressed with how much easier it is for us, and everybody else who has a modicum of training, to determine what a business is worth, and what the dynamics of the business might be, compared with estimating the prices at which a non-arbitrage security will sell in near-term markets.” Martin J. Whitman, Chairman of the Board, Third Avenue Value Fund

A dangerous side effect of not embracing the unpredictability of short-term stock prices is extreme bouts of anxiety when stock prices do not behave as the investor hopes they will.  Forgetting that short-term stock price movements can also be irrational can cause investors to question their decisions even when their decisions were sound and prudent in the first place.

Anxiety typically leads to knee-jerk reactions and excessive trading in their portfolios.  In short, emotionally-charged investors have a tendency to sell when they should buy and buy when they should sell.  Fear engenders irrational sell decisions, and greed provokes unreasonable and aggressive purchases.  In both cases, investors are more likely to lose than they are to gain when emotion dominates reason. As a result, I suggest that investors heed the Wall Street maxim – “in times of crisis, money moves from weak hands to strong hands.”  As investors, we should strive to be those with the strong hands.

Stock Prices Are Often Pathological Liars

On October 13, 2016, I wrote an article titled “Why I Am Now Interested In CVS Health Corporation.” In the article I pointed out that the market was significantly overvaluing the shares of CVS Health Corp (NYSE:CVS) for most of the years 2014 and 2015.  In other words, this was a classic example of the market pricing a stock in excess of what fundamentals would indicate.  Over this timeframe, I am putting forward that the market was telling a lie regarding the true worth or value of this excellent company. Consequently, the approximately 32% drop in CVS’s stock price since July 31, 2015 was predominantly attributed to overvaluation.