Eye On The Markets

How To Make Market Volatility Your BFF​

If we are willing to acknowledge that we can’t predict the future, we can move through the uncertainty more productively

by Steve Selengut

Mr. Selengut is a private investor and a contributing editor to LIFE&Health Advisor. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’ He can be reached at [email protected]

It matters not what lines, numbers, indices, or gurus you worship, you just can’t know where the stock market is going or when it will change direction. Too much analytical effort is wasted trying to predict course corrections… even more is squandered comparing changes in portfolio “market value” with unrelated indices and averages. The S & P 500 closed at 2,847.11 on August 26th, roughly 1% below the ATH (all time high) it struck 18 months earlier, and 6.4% below the one set precisely one month before. Over the past year it has hit at least a dozen new ATHs, and each time, for whatever reason, it has retreated just enough to raise the hair on the back of your neck.

Over the past 44 years, similar scenarios have not been uncommon (but absolutely unpredictable in terms of timing, duration, or dimension). It is extremely unlikely that this behavior is going to change, become predictable, or turn consistently “hedgeable”. … it’s what markets are all about; you just need to get into it.

We Can’t Predict The Future… OK?

If we are willing to acknowledge that we can’t predict the future, we can move through the uncertainty more productively and apply risk minimization techniques that make the volatility more palatable… enjoyable even, for some of us. Most people never forget their first love. I’ll (also) never forget my first profit… but the 600 1970 dollars I pocketed on Royal Dutch Petroleum was not nearly as significant as the conceptual realization it triggered.

Why would someone be willing to pay that much more for my stock than it was worth just weeks ago? What had changed? What had happened to make the stock go up, and why had it been that much cheaper in the first place? Without ever needing to know the answers, I’ve been trading Royal Dutch (and hundreds of other securities) for nearly 50 years.

Looking at scores of similarly profitable high quality companies over diverse industries, you would find that: most move up and down regularly (if not predictably) with an upward long-term bias, and that there is little if any similarity in the timing of the movements between the stocks themselves, or the sectors in which they are grouped.

Note that most multinational Investment Grade Value Stocks (Google Investment Grade Value Stocks – Selengut) could be included in many different sectors, as can many equity CEFs.

So This Is Volatility…

So this is the “volatility” that most people (and the media) are constantly, hypothesizing, cautioning, lamenting, and scratching their heads about. It can be narrowly confined to specific sectors, or much broader, encompassing practically everything. The broader it becomes, the more likely it is to be categorized as either a rally or a correction.

The growth in derivative products (index funds, ETFs, and CEFs) has increased volatility in the market averages by multiplying the indirect pressure on individual stock prices, somewhat invisibly. Stocks with higher ETF ownership display significantly higher volatility levels.

Derivatives also transfer investment decision-making from professional to amateur investors… food for thought when it comes to risk minimization. Most years will feature one or two rallies and a similar number of corrections… with a trend that may go in either direction. But, and if you can wrap your head around this one giant “BUT”, your investment light bulb will remain lit… forever.

Volatility and uncertainty are the natural order of things in the stock market… Mother Nature, Inc., if you will. Don’t take her for granted when she gets high, and never ignore her when she seems low. Embrace her volatile moods, work with them in whatever cyclical or random direction they travel, and she will become your investment “love” as well.
Ironically, it is this natural volatility (caused by hundreds of variables: human, economic, political, natural, etc.) that is the only real “certainty” existent in the financial markets. And, as absurd as this may sound (until you find yourself in the midst of a financial crisis without a secure income) it is this one and only certainty that makes Mutual Funds in general (and Index Funds in particular) totally unsuitable investment vehicles for anyone within seven to ten years of retirement.

The “Working Capital Line Dance”

The “Working Capital Line Dance” chart from page 207 of “Brainwashing” shows how the investment process is simplified with two basic changes of focus. If you concentrate on growing working capital instead of portfolio market value, and base income (potential spending money) instead of (totally unspendable) total return, volatility will become the engine for portfolio growth that “Momma” intended it to be.

Derivatives also transfer investment decision-making from professional to amateur investors - food for thought when it comes to risk minimization. Most years will feature one or two rallies and a similar number of corrections, with a trend that may go in either direction...

There are four basic risk minimization tools at your disposal. Oversimplified, they are Quality, Diversification, Income, and Profit Taking. If any of these tools is missing in your process, performance (the achievement of your personalized, specific goals) will suffer. Volatility is not a risk, it is a perceptual inconvenience for the uninformed. You need to embrace the opportunities that it produces to bring it to VBF status as I did decades ago.

If you select only high quality securities and diversify properly, volatility will remain aggravating and even unnerving. But if you have income production from all securities, and flexible (while reasonable) profit taking targets, you will be able to take advantage of every gyration, up or down, every time, to produce the upward only lines shown in the “line dance” chart above.

Note that this approach works best with at least 40% invested in income purpose securities and when less than 70% of the annual “base income” (income exclusive of net capital gains) is removed from the portfolio.
There will always be volatility, rallies, corrections, market, economic, and interest rate expectation cycles, and random news stories that rock your market value world. There have been three major market meltdowns in the past forty years… think about how an income and working capital focus would have changed things for you.

Corrections And Rallies

There have also been at least ten less spectacular corrections followed by rallies that brought the market to significantly higher levels. The DJIA peaked at 2700 before its record 40% crash in 1987. But at 1700, it was still 70% above the 1000 barrier that it danced around with for decades before — always a higher high, rarely a lower low.

The ’87 debacle was followed by several slightly less exciting corrections, but the case was being made for a more flexible, and realistic, market cycle based methodology. A long-term view of the investment process eliminates the guesswork and points pretty clearly toward a trading mentality that embraces the natural volatility of higher quality, income producing stocks, and both equity and income Closed End Funds. Such an approach:

  • Had you adding to your equity holdings during the ’87 crash.
  • Kept you away from Mutual Funds, New Issues, and NASDAQ before the dot.com bubble burst, and
  • Kept the income flowing for spending and reinvestment during the Financial Crisis

Throughout all three crises, both income and working capital continued growing while market values tanked and total returns went quietly negative.

Everyone is in the stock market these days whether they like it or not, and when the media fans the emotions of the masses, the masses create volatility that rarely under-reacts to anything. Rarely will unit owners take profits with the threat of withdrawal penalties or taxes. Even more unusual are investors with the courage to invest selectively when prices are falling.

A volatile market creates opportunities with every gyration, but you have to transact to reap the benefits. A necessary first step is to recognize that both “up” and “down” markets are forces of nature with abundant potential… the technical term is opportunity, and either direction can be beneficial quickly in significantly volatile environments.

Most investment strategies require answers to unanswerable questions, in an effort to be in the right place at the right time. Indecisiveness doesn’t cut it with Mamma… in or out too soon is not an issue with her. But wasting the opportunities she provides really ticks her off.

The Nature Of The Stock Market

Successful investment strategies require an understanding of the forces of stock market nature, and disciplined rules of portfolio management. If you can transition into managed equity portfolios that trade like stocks (i.e., CEFs), you will do better at moving toward your goals, most of the time, because the opportunities are out there, all of the time.

So let’s adopt some new rules for this investment game and learn to live with them for a few cycles: Let’s buy only IGVSI stocks, and equity CEFs at lower prices during corrections. Let’s take reasonable profits on those that go up in price, whenever they are kind enough to do so. Let’s examine our performance based on the annualized results of our trading transactions, the income our portfolios produce and the growth rate of both our projected annual income and our productive working capital

And one final thing: let’s drink a toast to an uncertain and volatile Mother Nature Inc., and, of course, to our first loves.