Stocktake: Living with volatility in 2015

Market volatility is a little like crime – people always think it’s increasing, even when the evidence suggests otherwise.

"If there was one common theme that ran through world stock markets this year," a recent Telegraph piece argued, "it was the surge in volatility."

Really? The Vix, or fear index, averaged 14 in 2014 – way below its historical average (20) and the lowest level since 2006.

According to the Price Action Lab blog, just 6 per cent of trading days registered declines in excess of 1.36 per cent or increases greater than 1.47 per cent.

It has been more than three years since the S&P 500 suffered a double-digit correction. In Europe, the German Dax and French Cac 40 eked out tiny gains, while the FTSE 100 slipped 2.7 per cent.

Heart-stopping stuff.

Volatility may well increase in 2015.

After all, intra-year declines have averaged 14.2 per cent since 1980, as a recent JPMorgan report noted.

However, volatility itself is no cause for concern – of those 34 years, 26 ended in positive territory.

The problem is that many investors, conditioned by media hyperbole, will overreact when markets inevitably wobble.

To borrow from investing author Nick Murray, the ability to distinguish between volatility and loss is the first casualty of a bear market. Airlines and disaster investing Shares in AirAsia plunged as much as 13 per cent following the recent crash of flight QZ8501, their largest one-day fall in three years.

Was this a mood-driven overreaction or a rational reassessment of the airline’s future?

The former is more likely the case.

Analysts point to the airline's hitherto unblemished safety record, as well as the gradual recovery in Malaysia Airlines shares, which lost value in the aftermath of last March's mysterious disappearance of MH370.

Additionally, the effect of aviation disasters on stock prices tends to be fleeting. One study, Sentiment and Stock Prices: the Case of Aviation Disasters, examined market reaction to airline disasters over a 57-year period.

Initially, panic ensues – on average, losses in market value are more than 60 times greater than the eventual economic costs, with disasters even catalysing a spike in stock market fear in general.

However, smart investors soon dive in, resulting in shares quickly recovering lost ground.

There are two lessons to be learned.

One, “mood and anxiety”, not fundamentals, can drive stock prices.

Two, disaster investing may seem heartless, but it may be very profitable.

More foolish market forecasts It's that time of year again, when the Mystic Megs of the investing world gaze into their crystal ball and tell us what's in store for 2015.

Forecasting is a fool's game. After all, who forecast that the price of oil would almost halve, from $110 to $57, in a few short months?

Not the economists surveyed by the Wall Street Journal this time last year – the consensus was that oil, then about $92, would end the year at $94.65.

As for 10-year US bonds, 48 of the 49 economists said yields would exceed 3 per cent. Instead of rising, they fell 27 per cent, ending the year at 2.17 per cent.

My prediction for 2015? Prices will fluctuate.

Buying into fear The best new year's resolution is also one of the simplest – do more of what works and less of what doesn't.

For short-term traders, suggests psychologist and TraderFeed blogger Brett Steenbarger, that means buying into fear.

Since 2006, Steenbarger notes, when the Vix, or fear index, has been in its highest quintile, average returns over the next five days are twice as high as usual.

When the number of stocks trading above their 20-day average is low, average five-day returns are five times higher than usual.

When the number of stocks making five-day highs is low relative to the number making five-day lows, average five-day returns are nine times higher than usual.

All too often, traders (and investors) do the opposite, selling into weak markets for fear that a market crash is beginning, or buying new highs for fear they will miss a big market move.

Betting against market fear isn’t easy, but Steenbarger’s data suggests it’s much better than going with your gut.

Big gains ahead or market bull? The US bull market may be almost six years old, but it won't end in 2015, according to some market astrologers.

Why? Because the year ends in 5.

Since 1885, according to the Stock Trader’s Almanac, all but one year ending in 5 has seen positive returns, with the Dow Jones Industrial average enjoying an average annual gain of 28.3 per cent.

Needless to say, we wouldn’t bet the farm on this one. Beware of spurious correlations.