Volatile Opportunities in These Trying Times

by: James Picerno

These are the times that try investors' souls, pinch their wallets and raise questions about what constitutes sound thinking on investment strategy.

No, we don't have definitive answers, but we can at least take a stab at dispensing some perspective, albeit informed by limited information that afflicts the mortal senses. With that caveat out of the way, perspective starts with the fact that volatility, as much as it scares us, is a good thing for strategic-minded investors. And the market has been nothing of late if not volatile.

The VIX index, a measure of S&P 500's price volatility, has taken wing in recent weeks, effectively tripling from its close at the end of last year, as the chart below illustrates. Dramatic as the new trend is, the resurrection of risk isn't all that surprising.

SPX Volatility Index

This past January we asked: Is Volatility Set for a Comeback? At the time, pondering a future of revived risk was widely dismissed as misguided ramblings. The bulls, you may recall, were then basking in a rare state of total control over asset classes. Everything had been rising for five years or more, and in the process price volatility fell sharply. The markets, in short, were priced for perfection, as they say. The fact that the perfection came after five years of fun suggested that it was time to prepare for something else. The timing and catalyst that would usher in change were still mysteries in January 2007. But the future seemed clear for those who believed that risk can't stumble and stay abnormally low forever.

Today, the cloud of unknowing has been withdrawn, leaving volatility in an elevated state. This is par for the course with dramatic market declines. What does it mean? From a strategic standpoint, the lesson for us is one of shifting the mindset from raising cash (which we've been inclined to do, albeit slowly, for the last year or so) to looking for opportunities to start nibbling at the major asset classes.

For the moment, the shift in sentiment is academic. Having made no purchases in recent weeks, we're still all talk and no action. But one shouldn't underestimate the importance of changing one's intentions from that of a net buyer of liquidity to a net deployer. Buying on the margins when markets are falling is as emotionally difficult as raising cash on the margins when markets are rising. Contrarianism - even a slow-moving, risk-averse variety such as ours - tends to be a thankless task in the short run, particularly in roaring bull markets.

Regardless of the backdrop, it's emotionally difficult to alter one's strategic thinking on a dime. Rethinking and revising one's big-picture portfolio plans takes time because the process starts in the last great black box in the universe: the control center of the central nervous system. But the revision becomes essential at various moments over time for the simple reason that buying low and selling high is still the only game in town for the long run.

Alas, your editor is as clueless as everyone else about the precise timing of bottoms and tops. The next best thing is adding a strategic overlay of time diversification to asset diversification. Having created a pile of cash, we now aim to use it, albeit methodically, deliberately and in pieces. Ideally, the cash will be deployed at moments of extreme stress in the coming weeks, months and years.

Of course, perhaps the selling will blow over. As we were writing this article, we read that the Federal Reserve this morning has cut the discount rate by 50 basis points. S&P 500 futures responded with a dramatic 2% rise. Perhaps the financial crisis has passed. Perhaps not. We don't know. But from out perch, the crisis wasn't triggered because interest rates were too high by 50 basis points. As such, it's hard to imagine that a 50 basis-point cut in the discount rate will cure what ails the financial system. Yes, it may bring temporary relief. But it's our belief, naive perhaps, that something more fundamental has upset the former rosy state of affairs. Until and if that's addressed, one might wonder if the recent turmoil still reflects deeper issues.

Even assuming that the bulls resume control, the inevitable correction will be that much bigger. With that in mind, it's our guess that many investors have not been raising cash these past months. For those who are still fully invested, a market decline leaves no option other than to sell. In contrast, those with cash will be willing and able to help out for those on the other side of the trade, at a price.