Saturday, August 04, 2007

Rising Volatility Means Stocks Can Go Lower

Given the sell-off in stocks we are now seeing, I decided to post my recent comments from the Forbes Growth Investor:

Volatility is back on Wall Street. There were 21 trading days in July. The range between the Dow’s high and low exceeded 100 points on 13 of those days. It exceeded 200 points on six days.

The CBOE Market Volatility Index is another way to monitor volatility. This index measures implied volatility from the prices traders are willing to pay for stock options. Implied volatility was rather low during the second half of 2006. It started rising in late February 2007, breaking through its 200-day moving average. It has now reached its highest levels since 2003. Traders love this kind of market. It gives them plenty of opportunity to make quick profits by jumping in and out of stocks. Long term buy-and-hold investors, however, may not pay much attention. They should. Rising volatility can sometimes signal a major turning point in the market. In 2003 it signaled the start of a bull market. Today, it may be telling us just the opposite.

Rising volatility means investors are getting nervous. They no longer feel confident about the market’s overall direction. Of course, much of the current volatility is being blamed on woes in the sub-prime mortgage market and on worries that those problems will spread to higher quality mortgages. Yet even today, there are those who seem to be completely discounting the deterioration in housing. They seem convinced that the housing market is about to bottom and that any further problems—if they do occur—will have only a minimal impact on consumer spending.

Economists will debate exactly how much investors should worry, but one thing is for
sure: This bull market is getting old. As a result, many investors are sitting on sizable gains. When they see stock prices gyrate excessively, they can’t help but think about taking profits. They probably should take some money off the table.

It’s likely that housing prices will continue to fall. In fact, the 10-city S&P Case/Shiller Home Price Index recently posted its biggest drop since 1991. Furthermore, oil is trading for more than $78 per barrel and some analysts predict it will hit $100 within a year. Yet so many otherwise meticulous market watchers are simply overlooking the price of this indispensable commodity. To them, the price of
oil does not matter—until, of course, when it does.

Despite seemingly strong GDP growth in the second quarter, stocks are likely to go lower. Those who are truly worried about further declines, but for tax purposes are reluctant to realize gains, should consider hedging their portfolios. One good way to do this is by buying one or more of the UltraShort ETFs. These move opposite in direction to the corresponding index, but by twice as much. For example, the DXD will rise 10% in value if the Dow falls 5%. The SDS provides a similar hedge against the S&P 500. Readers can learn more about these products at