Is This a New Age of Volatility Inspired Opportunity?

by: James Picerno

Judging by Monday morning's update of the ISM services industry index for October, the economy doesn't look all that bad. But there are an infinite number of ways to judge the economic outlook, and for the moment, it appears that more investors are inclined to judge the glass as half empty rather than half full.

The stock market certainly found no reason to cheer in the wake of Monday's ISM news. Yes, services now dominate the U.S. economy compared with the diminishing role of manufacturing. In fact, as the chart below shows, the October rise in the ISM services index exceeded expectations as upward momentum in the sector took root last month. David Sloan, an economist at 4Cast Ltd., told Reuters that:

The [ISM services index] numbers are pretty good. It suggests the service sector is growing at a decent pace so the economy is not in too much trouble overall, at least for the moment, despite the weakness in housing.

As such, one might think that a favorable reading for the index would dispense a bit of optimism. Not on Monday, at least not as we we wrote this at roughly halfway through Monday's trading in New York. U.S. stocks opened sharply lower Monday morning, although the losses were pared by noon.

What's going on? Part of the explanation is that the news on the continued health in services was overlooked in the face of fears that Citigroup's (NYSE:C) credit-related losses are far larger than initially thought. In turn, that's inspired a new round of worries that the pain in the financial sector will get worse before it gets better. That dark thought, combined with ongoing problems in real estate, suggests to some that the odds of a recession are still rising.

In his November economic outlook, Kurt Karl, chief U.S. economist for Swiss Re wrote:

The continued housing weakness, coupled with the ongoing credit crunch and rising oil prices have increased the risk of recession to about 40%. Though the Federal Reserve Board continued its monetary easing with another 25 basis point cut in October, it is too early to determine if the economy will escape a recession.
He recognizes that the latest employment report was "strong." On the other hand, Karl added:
Many near-term indicators are weak, implying growth will slow from its 3.9% third quarter pace. At this time, the next few months of data releases are likely to be dismal, forcing the Fed to lower the federal funds rate to 4.0%.

What's more, some of the problems that are worrying the market aren't limited to the U.S. Isabelle Delattre, fund manager at Raymond James Asset Management, told AFP that:

Concerns about European bank exposure to the subprime market have resurfaced after last week's announcements from U.S. banks. The full truth (on banks' subprime exposure) has yet to be fully uncovered.

If the jury's out about what's coming, it's getting easier to think that higher volatility in the capital markets will be with us for some time until the future becomes a bit clearer, one way or the other. For instance, the Chicago Board Options Exchange Volatility Index, or VIX, is on the rise again. Given the uncertainty swirling of late, one could imagine that the VIX will climb higher, still.

Get used to it, counseled Milton Ezrati in his latest economic analysis (pdf). Senior economist and market strategist with Lord Abbett, Ezrati wrote that S&P 500 volatility, measured in standard deviations, has nearly doubled between the first six months of the year, and the July–October period. What should investors do? Exploit it.

Ezrati advised that:

As upsetting as downside price swings can be, investors making regular contributions to their investment plans actually have reason to welcome such price moves. After all, the downswings do enable the plan to buy more assets at lower prices.

And, we might add, lower prices imply higher prospective returns.

Nonetheless, being a contrarian never comes easy - an iron law of investing that may be tested in the extreme in the weeks and months ahead. Of course, comfort in the here and now may come at a high price in the long run in the form of lesser performance.

Or, as Ezrati recommended:

No one, whether an individual opening his or her personal statement or the head of a huge pension fund or foundation, feels comfortable watching gyrations in price and in the value of assets. But, as should be clear, the swings can work to the advantage of a steady, long-term investor. Since volatility also can provide opportunities for an active manager that would not exist if the asset were to appreciate along a steady trend line, price swings are an aspect of markets that investors could truly learn to love.

Thus, that leads us to the question du jour: Are we entering a new golden age of volatility inspired opportunity?