Volatility Reigns

Through more than 46 years in the investment business, I have never before seen such extraordinary price volatility as has characterized the U.S. stock markets over this past year. In that time, the Dow Jones Industrial Average has alternated directions 33 times by amounts ranging from 300 to 2000 points.

INDU 1 year with annotations

Twenty-nine of those moves have occurred in the most recent eight months, an average of an almost 600 point change of direction roughly every six market days. Last week, one of TV’s talking heads stated that we haven’t experienced such volatility since 1904. At the very least, this is far from a normal investment environment.

The Dow closed Friday almost 600 points below the beginning level of the eight months of wild vacillation, and about 1000 points below its May high. The indecisive fluctuations have brought prices back to the level of late-October 2014. Clearly, neither bulls nor bears have been able to gain control. Such indecision is similarly characteristic of stock markets around the world. About half of those markets are up for the year-to-date, half down. About half are trading above their 200-day moving averages, half below.

While many markets are only a few percentage points below their all-time highs, there are clear signs of fatigue showing. The current U.S. stock market rally is already longer than most. With each new index high, fewer and fewer stocks are reaching individual highs. In fact, in recent weeks, more stocks are hitting new 52-week lows than highs. More than two-thirds of stocks in the broad Russell 3000 are trading 10% or more below their recent highs. A growing number are more than 20% below such highs.

While these market conditions typically precede important stock market declines, they are not precise timing tools. Major market indexes can continue to reach new highs even with fewer and fewer individual stocks participating.

The current market advance has seen greater government intervention worldwide than ever before. At virtually all the lows in the past year’s trading range, central bank or other government officials have stepped forward with actual monetary stimulus or at least promises of probable support. Such support has successfully prevented significant price declines even as major international forecasting organizations continue to reduce their estimates of U.S. and global economic growth. On the other hand, such intervention has been unable to stimulate prices to break above the top of the multi-month trading range.

We are increasingly learning that governmental intervention has taken the form of actual stock purchases. Most notable has been the commitment during the past month of nearly $500 billion by China’s government to prevent a potential stock market collapse. Japan continues to boost its market and others with massive stock purchases, both domestic and international. Switzerland, long considered a bastion of financial sobriety, recently reported that it purchased international stocks totaling 17% of its current Gross Domestic Product. The widely respected Zero Hedge website speculates that the U.S. has similarly stockpiled a huge portfolio in its effort to support stock prices. I have long believed that the Fed or Treasury has been strategically buying stocks, either directly or, more likely, through a surrogate. Such purchasing can continue to support markets indefinitely as long as governments believe they can print money or dedicate reserves to growing a national equity portfolio. Governments, however, have a less than positive track record with asset purchases over past decades. They have, for example, been widely ridiculed for stockpiling gold near all-time highs and selling gold reserves near major lows. There is little reason to expect their investment expertise to have improved.

According to Bloomberg, a few months ago, Matt King, global head of credit strategy at Citigroup, made the point that stock markets have become reliant on monetary support. He estimated that central banks need to pump about $200 billion into the global economy every quarter to keep stocks from falling. Without such stimulus, King estimated that stocks could drop by 10% quarterly, at least initially.

For several quarters, we have characterized the investor’s dilemma to be whether to bet on the continued success of central bankers supporting markets or to trust that deteriorating economic and stock market fundamentals will ultimately prevail. While history argues convincingly that fundamentals will dominate, governments remain on a multi-year winning streak. As prices and the soundness of fundamentals experience a growing divergence, however, the potential for a major market collapse increases. Such is the probable unintended consequence of years of unprecedented governmental interference with free markets.