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From 1974 to 2008, US household debt expanded from 43% of GDP to 100%. During this same period total US debt – household, non-financial business, financial business, and government – grew from 150% of GDP to 350%. Little wonder that this same time frame gave us an explosion in values across all asset classes. Similar or even worse trends occurred in most countries.

When the reality of this credit binge hit home in 2008 everything changed; western economies stumbled badly, asset prices and financial markets and personal wealth shrank, large swaths of debt were transferred from private to government ownership and unemployment ballooned.

Pimco’s ‘new normal’ is upon us; several years of sub-par growth as we cope with higher taxes and debt pay-down. But the massive debt assumed by western governments has come with an additional price - huge volatility.

The current worry du jour is centered on Greece’s inability to service its debt mountain. And specifically on the negative consequences for other sovereign debtors and for an already fragile European and global banking system that would occur if Greece sought to restructure its obligations.

Tomorrow’s worry may be about a double-dip recession as the various government stimulus packages come to an end. Or financial and economic problems within euro countries as German citizens are asked to pay for ever more obligations of other nations. Or some other big issue? Take your pick. Clearly the global debt problem is too enormous to quietly slink away. After-shocks will reoccur again and again over the next number of years.

However, it’s not all bad news.

The various government stimulus packages are producing results. All major economies except the very worst serial offenders have returned to some form of growth, companies are reporting much higher profits, sales data is turning positive, financial markets and bank confidence have improved markedly since spring 2009, and unemployment data is gradually becoming less negative.

Also, there is a growing consensus that the economic momentum gained in recent quarters will transmute into continued forward growth even with the expiry of the stimuli. On May 26th the OECD – who it must be noted are not infallible – revised up their global growth forecast (.pdf). They predict US growth of 3.2% for both 2010 and 2011, Europe managing 1.2% in 2010 and 1.8% in 2011, and continued buoyant growth in emerging countries including China at 11.1% for 2010 and 9.7% in 2011. Whilst the OECD does identify various risks they, nonetheless, predict global growth of 4.6% in 2010 and 4.5% in 2011. Strong numbers by any measure.

For sure we live in a changed world. A world of gradual and uneven long term recovery dotted with periods of stomach-churning volatility. And whatever volatility inducing occurrences do arrive, investors can be sure their impact will be accentuated by wave after wave of coverage by the business TV channels .

Recent events are a case in point. After the DJIA bottomed at 6,440 on March 9, 2009, it then gradually advanced whilst experiencing periodic and increasingly large oscillations, culminating this past five weeks with a pull-back from 11,309 to 9,756, a loss of 1,553 points or 13.7%. Whilst the market was dropping we have had a plethora of TV personalities explaining why the entire Euro region might break up, how China’s economy will slow and how its property market bubble will burst, and so on. Clearly the world is ending.

The DJIA closed out May at 10,137 – off 10.36% from the April high – representing the worst month-of-May on record since 1940. What belies this relatively unspectacular drop in the main index is that the combination of the 10% downward momentum in the main indices, plus the beat-to-death coverage of negative news flow on TV, badly frayed the already raw nerves of individual investors. Consequently, small stocks have been hit much harder, often by 20-30% and, in many instances above 30%, or even 40% occasionally.

It is not mere coincidence that the market dropped in late April and in May. With a huge sovereign debt worry as a backdrop, it is inevitable that markets will soften when there is no ‘strong earnings news’ to offset the talk of sovereign debt panic that fills our TV monitors. It is only natural that human beings would be swayed in this way. Thus, over the next six weeks, as we approach what will surely be another strong earnings season, markets will again move up. Similarly, unless we hear of some new and miraculous solution to the sovereign debt problem, we should again anticipate market softness when the positive news flow from the Q2 earnings season begins to ebb in August.

Furthermore, because investors have learned the hard lesson from the recent Q1 earnings season sell-off, I believe the August sell-off will have more participation, leading to bigger market falls.

During the past week a handful of chartists gave their various forecasts for market direction over the coming weeks and months. Invariably they stated that the market; (a) has indeed put in a recent bottom, (b) should advance nicely for a few weeks without making new highs, and (c) should then enter a further period of weakness.

What has become clear in 2010 is that, given the severe hits to many mid/small cap stocks, especially those that experienced a haircut of 30% or 40% or more, it would have been much wiser to have not invested in them at all, and to now buy these very same stocks at compellingly cheaper entry points. Oh, the value of hindsight.

However, whilst we cannot turn back the clock, we can recognise what has occurred and use the situation to our advantage. Instead of sticking to a buy and hold strategy, I believe investors should, to varying degrees depending on risk appetite, learn to use market volatility to their advantage i.e. Embrace Volatility.

In addition to holding a core portfolio of quality stocks and/or other instruments, investors would do well to allocate a part of their overall portfolio as follows:

(a) Do short-term trades with liquid, high beta, deeply discounted small or mid-cap stocks that should yield 10-20% or more during multi-week periods when the overall market is in up mode. Purchases should be made early in the up-cycle, after recent market bottoms have been confirmed. The trades should be executed when both the overall market RSI and the individual stock RSIs are weak. All these short-term positions should be sold within a number of weeks, certainly when overall market and/or individual stocks RSI’s are high.

(b) When overall market indices are toppy, especially if there are strong RSI readings towards the end of earnings season, buy a series of out-of-the-money put options in liquid high beta stocks, in order to give the core portfolio some downside protection in the event of volatile periods returning (which they invariably will). Furthermore, if and when markets become periodically and clearly overbought, investors should seriously consider cashing-in to a greater or lesser extent.

The degree to which individual investors can embrace volatility depends on many factors, not least overall market direction, investor risk appetite, execution skills, and portfolio size (should work up to a few million $). That said, I believe that if investors are patient enough to allow many iffy opportunities to pass by, and only go for very high probability plays, that they will reap very good rewards.

On a separate note I will detail a list of 6 stocks that offer excellent short-term trading potential for Q2 2010. They are culled from a full list of 119 stocks of which all are detailed.

Warning: Be patient and careful out there. Do not chase volatility, let it come to you.

Disclosure: No positions

Source: Investment Strategy for Volatile Markets – Embrace Volatility