Volatility Is Up And Stocks Are Down

by: Vahan Janjigian, CFA

Last year, the S&P 500 surged more than 30% (including dividends). Last year stocks rallied on any news. Last year, good news was good news and bad news was good news. If some economic indicator was better than expected, investors pushed stocks higher on the expectation that the economy was indeed improving. If some economic indicator was worse than expected, investors pushed stocks higher on the theory that the Fed would have to provide more easing.

This year, nothing is going right for stocks. As shown in the graph below, volatility is on the rise. This year, bad news really is bad news. Monday's sell-off is the latest sign of nervousness. Investors were already worried about a slowdown in emerging markets, including the biggest emerging market of all -- China. Even though futures indicated an up market on Monday morning, stocks sold off anyway. The selling got into full swing soon after the Institute for Supply Management came out with its widely followed Purchasing Managers' Index for the month of January. At just 51.3, this measure of manufacturing activity was much lower than expected. Since the number is above 50.0, it continues to indicate an expansion in manufacturing. However, economists were calling for a reading closer to 56.0. Not only was the actual number worse than expected, it was also much worse than December's reading of 56.5.

It wasn't just the lousy PMI report that motivated investors to sell. Both General Motors (NYSE:GM) and Ford (NYSE:F) reported big sales declines for January. Last year, this double dose of bad news might have caused a rally on the bet that the Fed would postpone any thoughts of tapering. But the tapering has already begun and investors know that the Fed is not likely to reverse course. So, they responded by selling everything.

However, there might be a special circumstance that explains January's woes. While economists are warning that there will be more disappointing figures coming out, they are also suggesting that much of the weakness in January is weather related. Recall that January was the month when we all learned about something called the Polar Vortex. The weather got so cold that airlines canceled 27,779 flights between Jan. 2 and Jan. 9. There is no chance that the damage was contained to just airline companies. You can bet the retailers were affected, too. The weather was so cold in many parts of the country that no one in their right mind would have gone on a shopping spree.

With stocks up so strongly in 2013, a bit of a sell-off is expected. Indeed, a healthy bull market requires a pullback every now and then; and many bulls have been hoping for a correction. With Monday's sell-off, the S&P 500 and the Dow Jones Industrial Average are down 4.9% and 6.5%, respectively, year to date. But will investors jump back in if stocks go a little lower? Maybe not. To a large extent, stocks rallied last year on the anticipation of an improving economy. For the rally to continue, the economy has to do much better than anticipated. Friday's employment report may provide another key piece of information that could move the market in one direction or the other.