Don't Fear Volatility...
January 18, 2025
I listened recently to an interview with Cliff Asness, a successful hedge fund manager. Before embarking on his investment career, Asness, a bit of a math geek, earned an MBA and a PhD at the U of Chicago, in the process studying and working closely with Eugene Fama. Fama is a Nobel laureate renowned for his postulating of the ‘efficient market’ theory. In simple terms, that theory suggests that asset prices (e.g. stock prices) reflect all available information and therefore prices are what they should be. Asness does not subscribe to that theory and allowed as how he even heard Fama say as much himself – in effect, prices are not always ‘correct’.
I have no intention of getting all math wonky on you (presuming I even could which is most certainly not the case…good with numbers but far from a math geek). There is an essential truth here that could, and should, serve all investors in their decision making. Simply put, the stock market, and share prices, do not always behave rationally. There has always been an emotional component to investor decisions and now there is the added distortions generated by the algorithms used in computerized trading as well as the forced buying from index ETF’s (e.g. SPY, the S&P500 ETF).
A few issues ago, I pointed out the 38% jump in Broadcom because the CEO spoke optimistically. A reader sent me a note to remind me that that knife cuts both ways – a company projects that it will grow revenues by 24% and then reports growth of 22% and the stock takes a major hit…what, 22% growth is not meaningful? Please. The point being made here is that share prices often act over optimistically and/or over pessimistically while the underlying fundamentals have not changed nearly as much as the stock price movements would imply. This is especially the case in a market focused more on growth as we have had for some time, basically highlighting the rise of importance of technology in the markets and in our daily lives. Valuations have climbed and similarly so has the potential for volatile reactions on both the upside and the downside.
When the markets are more volatile, it would be reasonable to expect the average investor to find that a little unnerving, to say the least. Long-term investors, though, shouldn’t fear volatility. Volatility creates opportunities to buy at lower prices and to harvest gains at inflated prices. If you own shares in a company whose story remains essentially the same but there is a hiccup due to some minor surprise in what it reports, consider adding to your position. Similarly, if the hallelujah chorus on some slightly better than expected news/earnings report gets too loud and carried away, trim a little and have the cash to deploy elsewhere.
I have been thinking about this for several reasons. For one thing, with the market trading at an elevated valuation, the greater risk is to the downside. If something triggers negative sentiment, a swift market decline could cause widespread price drops, including unmerited ones. A chance to buy that stock you missed investing in before or to add to a position in a company you find really worthwhile. Still, elevated valuations have been the case for many months now without any sustained corrections, swift or otherwise.
So why write about this now? For two reasons. First, opinion amongst the pros is very divided (e.g. Barron’s annual Roundtable parley amongst a dozen investing veterans). There is lack of agreement on inflation, future rate cuts, market valuation as a threat to profitable investing…basically, a feeling of uncertainty is being projected. The markets do not like that and volatility could be an outcome. The other reason is the imminent (two days from when you are reading this) induction of Donald Trump as President. Regardless of how one feels about that, it is a fact. What is also true is that Trump has shown a tendency to be impetuous, to take unusual positions, to insist on interpretations of situations that may lie well outside commonly accepted understandings of such matters. And that is a recipe for surprising remarks, strong reactions, and unexpected consequences, and…wait for it…increased market volatility. Do a little preliminary work and have some ideas ready so you can react decisively when a good chance presents itself.
My thoughts are also with friends who have weathered the fires in LA…the stories are sad, the reality for some must have been frightening. I expect they will find the reslience to rise from the ashes, literally and figuratively and I am rooting for that. In contrast to blazing, out of control heat, it is cold in my neck of the woods and about to get even colder. Streaming, football, and some good reading on the menu. Have a nice weekend.