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Wednesday, 28 June 2017
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Volatility is a Bastard

(Understandably) Shitty Members - I have received a couple of emails recently – Members annoyed by the market. The first was sent the day after the market dropped an unexpected 92 points recently, against the morning leads:

  • “I know this will sound like a huge dose of paranoia/whingeing, and for that I apologise, but I can’t help thinking that we small investors are being manipulated. No wonder sentiment is low, and people are reluctant to invest. I can see absolutely no reason for the Banks to have gone down yesterday, other than some sort of window dressing/ tax loss selling by the big institutions. It makes a mockery of the share market, for us small time suckers who are topping up on Banks. I blame the incompetent regulators, who seem to condone everything, from window dressing, to short selling (which I abhor).  Market manipulation should be illegal, full stop!!  Too many vested interests for it to be made so, I guess”.

And this:

  • “What in hell is going on? In my view the stock market is becoming no place for retiree investors. It’s being influenced by too many forces outside our control or knowledge, things like shorting, computer based transactions, high-frequency trading and the activities of complex hedge funds with unfathomable investment objectives to name but a few.”

Massive Turn off - Volatility upsets investors. Market commentators, especially those CFD guys that rely on churn and burn, often suggest that market volatility is an opportunity, as if it’s a good thing, but really it’s not, it’s a massive turnoff and I fully understand my email senders. And let me tell you one thing in the newsletter game - If one Member bothers to write it you can guarantee 200 Members are thinking it. 

Volatility is a disturbance to retiree investors, and because it is accelerating, especially in the previously reliable bank sector, it has killed the concept of “safe income”. There is no ‘safe’ in equities. A point all retirees need to take on board. The scar tissue is still visible from the GFC, which is a good thing, no-one is dumb enough anymore to have the “faith” in the stock market that the whole financial advice industry preaches. We want less volatility but at the moment volatility is getting 'worse' by the day.  


Here is an Ad from a CFD provider on a financial website today – an example of the industry getting it wrong with investors:

"Take advantage of market volatility - Our unmatched execution speed gives you the upper hand when it comes to trading. Execute trades in just one millisecond on one of the fastest engines on the market. Losses can exceed investment."

Yeah right. Those milliseconds are going to make all the difference.


What is volatility?

I don’t need to copy and paste Investopedia to teach you the maths behind the measure of standard deviation and variance, the standard measures for volatility or risk. Instead let me show you two basic charts that make a simple point.

Here are two share prices that have done the same thing over the same time period. They have the same ‘average’ shown by the straight regression line. If you measure the average deviation of the snaking share price from this regression line (from the average performance of the share price), add them all up and average them you get a measure of volatility. With the first stock you get deviations averaging “x” = the standard deviation of the stock from its average. Hence the expression ‘standard deviation’.

Now look at the second stock. Same trend, same average (same regression line) but this time the stock has moved in bigger deviations from the average. Add up those deviations and average them and you get “2x” = so the standard deviation from the average is twice as much as the first stock but they have done the same thing.

This should highlight that some stocks are more risky than others - some move around more than others for the same end result. In which case, in financial theory, if you get the same return but are taking twice as much risk in the second stock, you would only ever buy the first stock.  

And that’s volatility. An investor would naturally want to maximise their return by taking the least risk, by minimising volatility.

Why is volatility getting ‘worse’:

  • Results Roulette - In the last results season in February, 51% of the two hundred and sixty odd major results moved more than 3% on the day of their results. 35% moved more than 5% and 11% moved by 10%. This volatility is a function of continuous disclosure requirements which mean a company can’t feed a message into the market anymore, it has to dump it. Some companies often haven’t said anything to 6 months so results can often surprise. Before rigourous continuous disclosure requirements companies would feed changing expectations into the market through select brokers and it would 'seep' in, not crash in. No more.
  • Computer trading is now also adding to the volatility as 47% of all orders entered into the market came from computers in the latest ASIC study in March 2015 (probably more now). 31% of all trades by number were done by computers. 27% of all turnover was executed by computers. 78% of all computer based orders were being done by just 10 big HFT players (High frequency traders) and the average holding time of an order in the market was 51 minutes. In the Futures market, which drives the equity market, the numbers are higher and increasing. If you then consider that 30% of market turnover is also being done off-market in "Dark Pools", anonymous order matching systems, then it looks like humans are only doing about 43% of market turnover and that was back in March 2015. It will be less now. High frequency trading chases volatility and in so doing exaggerates it. The algorithms that they run on detect other people’s orders in the screen, detects executed trades and short term price trends, in nanoseconds, and responds to that in nanoseconds without any consideration for fundamentals. The algorithms are also now electronically scanning the words of announcements, no humans involved, and picking up on adjectives and phrases like "profit warning" and "lowered guidance" or "raised guidance". And they instantaneously start placing orders in response. That algorithm activity is then picked up by the activity matching algorithms and WorleyParsons opens down 21.8% on the day of it’s last results, only to bounce 11.5% by the end of the day. Notably this all happens before any analysis is done by the brokers or the big institutional fund managers. The action stems from computer driven algorithms. And the idea that this is being done by individual retail investors sitting at home, is laughable. Retail investors cannot move WorleyParsons 21.8% on the open. But don't expect this situation to change - ASIC's study into HFT concluded that whilst it may be exaggerating short term price movements HFT was not disrupting the integrity of the market or materially raising the costs of execution enough to ban it. It is here to stay. ASIC is clearly happy to sit back and let it happen, and the ASX have no interest in limiting it because they are raking it in from HFT customers paying for high speed data feeds with terabytes of information being provided by the exchange at huge cost.
  • Sentiment can’t be measured – As one of the emails above highlights, it is frustrating that share prices can move significantly without any change in fundamentals. For instance, in the GFC, the bank sector fell 56.4%. Do you think the intrinsic value of the banks actually fell 56.4% and then recovered in the next couple of years? Of course not. If share prices 100% reflected nothing but fundamentals then stocks would be one heck of a lot less volatile and more importantly would be so much easier to analyse and predict. What the growing and unpleasant volatility highlights is the unsettling reality that a large part of share price performance is down to sentiment rather than value, down the fragile concept of behavioural finance rather than the hard numbers that underwrite fundamental analysis. And even the sophisticated investors that purport to gauge sentiment in a scientific way, really have no handle on sentiment as a measure, other than to look at the share price chart and the share price trend. It’s a fact of life, the value of a company is about fundamentals, but share prices are about sentiment and sentiment can  be wrong, by a lot, for a long period of time. As the classic quote says “Markets can remain irrational longer than you can remain solvent”.

The reason for all this is that we are no longer living in the 1980s. When I started broking in 1982, prices were quoted from human to human, between stock jobbers and stockbrokers, verbally on the stock market floor. They were then relayed by an astonishing invention called a two-way radio to the stockbrokers upstairs. Those brokers then rang the client on a bakelite telephone to tell them what the price quotes were from the four different stock jobbers, asking them politely if they would still like to place an order and have lunch. No wonder commission was 1.65% and it went higher for bigger orders (more risk for the broker on settlement). So there were four stock jobbers and two stockbrokers plus a client involved in executing an order, not to mention the back office shenanigans. In those days research was also written on lined paper with a fountain pen and sent to the typing pool. People could spell and use grammar and multiply seven by eight in their heads. A list of historic PEs was a research innovation. Service consisted of telling fund managers prices, describing what a company did and taking orders if you were a “good chap”. The phone never rang in your pocket whilst you were talking to someone and people didn’t look at their phones instead of you at lunch, because they didn’t have one. On top of that every broking house owned its own printing press and a messenger department to distribute the research by hand to all the fund managers in the City. The best clients got it first. Colours and charts were mind blowing when they appeared. Volatility in 1982 was when a share price on the new big Stock Exchange TV (one per Stock Broker office), moved more than 4 times a day, and you could only tell that by clicking the big change page button which rotated the TV through the 10 screens showing only the FTSE 100 stocks.

The bottom line is that you have to stop worrying about volatility and how unfair it all is, fast execution and the volatility that comes with it is here to stay, you simply have to accept it as a fact of life. And it will probably get worse. So rather than fight it, you have to live with it which means you need to work out how to handle it (see below).

CHASING INCOME IS BECOMING HARDER

This comment comes from our recent Dividend article on right.

If you really are a conservative retiree interested only in income, are living off that income and you really don't want to take risk or can't afford to, you should look beyond equities to Hybrids, term deposits or bonds (there are hundreds of funds that provide those exposures)

A lot of our clients at the "use it but don't lose it" end of their investment cycles do just that. They hold a lot of hybrids with our guidance. We rotate about a bit as new issues come on board, and we have to watch for them getting overpriced, but generally speaking they are earning around 6% on their money with very little real risk. You might do the same thing if you are conservative. 

And despite what you might read from some fixed interest experts, the issue with Hybrids is not the price, the risk and timing, the main concern is an unlikely but possibly seismic moment of significant financial turbulence like the GFC. Whilst almost all hybrids survived many of them had heart stopping dips. Most recovered and there was no harm done. But there were dips that would have sent conservative investors to their cardiologist, dips that in hindsight created some great trading opportunities, buying Macquarie prefs at 60c in the dollar was one of the best. Sometimes nothing is safe. At those moments cash is the only option. Far better you sacrifice 4% of income than you lose 56% of your capital. 

So whilst we in the equities game are trying to lure you in as income investors, the reality is that, as any Yank will tell you, bonds (and hybrids) are for income, equities are for growth and unless you are prepared for that, you should probably leave the equities out of it.

WHAT TO DO ABOUT VOLATILITY

I am on my third child learning to drive. Emma and I have already done 240 hours with Olivia and Charlotte (although I did most of the hours with Charlotte, Emma thought it was safer for both of them) and Jemima has just started at the age of 16. One thing I have told them all is this “You are driving the car, don’t let the car drive you”.

It’s the same in the stock market. You do not have to subject yourself to stock-market volatility. It is your choice. To control it you have a few options:

OPTION 1

Understand it - You can get a handle on volatility very easily using the Marcus Today ALL ORDS spreadsheet or via our patented STOCK BOX. CLICK HERE for the MT All Ords spreadsheet. There is a column in there that shows ATR = Average True Range, which is one measure of volatility. Investors should look at the weekly (rather than daily) ATR. It measures “x” in the charts above. “x” or the ATR is the average share price movement per week over the last 15 weeks (over the last three months).

Here is an example from the spreadsheet:

Looking down the list you can see that the fourth stock down (A2M as it happens) moves on average 10.2c every day and 20.7c every week (little tip, generally stocks move double the daily amount over a week). Now you can compare the volatility of stocks compared to each other by dividing how much it moves every day or week by the current share price. In the case of A2M the current share price (last night) was 336c. That means that the stock moves on average 2.6% a day or 5.3% every week. Now you can compare the relative volatility of stocks.

If for instance you go down to Telstra which is one of the least volatile stocks in the market you will find that it moves 1.7% a day on average, and 4.2% a week. So that’s your ‘low risk’ benchmark for equities. 2% and 4% might be an average low volatility stock. 

(Bear in mind that the ATR is over the last 15 days or 15 weeks. On that basis the stocks that have had the biggest shock price drops or rises in the last 15 days will have massive ATRs. As we write for instance, QIN, which may go bust and has collapsed 80% over three months, has an ATR of 33.5% daily and 56.6% weekly).

Another use of the ATR is to identify some of the best trading stocks. For instance GXY (lithium stock) is a traders favourite, it has a daily ATR of 6.2% of the share price, and a weekly ATR of 17%. As a trader you get bag for your buck. (for a good trading stock you also need liquidity). Most stocks will have an ATR of 2 to 3% of the share price on a daily basis and 4 to 6% on a weekly basis. 

Now you are able to gauge volatility and on that basis avoid volatile stocks, if you prefer, by looking at the ATR as a percentage of the share price on our spreadsheet. Put it this way, if you find a Mid-Cap stock that you like, just check the ATR on the spreadsheet and you’ll quickly realise whether you’re getting yourself into shark infested waters or an investment.

So Option 1 is to understand volatility and invest accordingly. Know your risk.

OPTION 2

Trade a diversified portfolio though ETFs and LICs. An index has much lower volatility than stocks (of course...the average of 200 stocks moving is going to be a lot less than one stock moving). If you trade an index it is like trading stocks in slow motion. 

If for instance you traded an ETF over the ASX 200 (STW) or an LIC like AFIC, which does a similar thing with a touch more brains attached, then you are going to avoid the “shock drops” you see in individual stocks. It’s rare that an index crashes – so rare we all remember when they do.

The main attraction of ETFs or LICs over an index is exactly this purpose, they are for people who have given up on the volatility of shares. Trading an ETF or an LIC is a lot easier, its a much quieter life making a few decisions each year about whether to be in the market or not rather than managing the volatility, decision making and paperwork of twenty separate equities.

In the ETF and LIC world your investment concerns boil down to timing a slow moving investment rather than managing events in individual shares which is more risky, volatile and tough to manage, as anyone that traded through the last results season will testify to. Results and AGM seasons are becoming a bit like wearing a flouro vest on the battlefield during an artillery barrage. You never quite know when you’re going to get blown up.

Talk to some traditional stock brokers and they will also tell you that trading shares is now a poor man’s game. Consequently most brokers are now moving into ‘Wealth Management’ instead of traditional transaction broking, they are coming around to the financial planner’s modus operandi which is to manage asset allocation across asset classes, as opposed to picking individual shares. Through ETF and LIC trading you can now do this yourself. Something that will suit anyone who is feeling that “There must be a better way” to avoid the volatility, profit warnings and stress of managing an individual share portfolio.

Trading ETFs, or managed funds, or LICs alone, is putting yourself in the slow lane and this is the ETF industry's best pitch in my opinion. “Stock picking is too hard, buy ETFs”. It’s a bit like Dudley Moore’s terribly successful advertising line in Crazy People in 1990. “Volvo. They’re boxy but they’re safe”. ETFs are boring but they’re safer.

With ETFs and LICs you can also attempt to do what a lot of financial advisers do, assess your risk profile then direct your money into asset classes in different percentages depending on how much of a chicken you are. Growth, Conservative, Balanced, or Cash. Just pick your percentages and its done.

But to truly get ETFs and LICs, or managed funds, right, there is still a bit of brain required. As an asset allocation style investor the returns come not from holding diversified or specific ETFs, but from timing them, timing your exposure to the markets.

ETFs are a bull market instrument that are deserted in a bear market. Sure you can buy and hold, but if you want to protect yourself from market risk, from a crash, from a GFC, you still have to pay attention and time the markets just as you would time a stock, although timing an ETF over an index is like timing stocks in slow motion. You have much less volatility and far more time because most of them don’t move much and you are not having to make a lot of stock specific decisions.  

The bottom line is that buying the big diversified passively managed ETFs over markets and other major asset classes are for those that want to avoid volatility.

Of course there are some pitfalls. The industry has overstepped the mark with some of its active ETFs. They should have just stuck to their knitting. But no, they couldn’t resist. Now we have all sorts of momentary fads available through dicky ETFs. As one colleague so rightly says, it’s a bit like brokers listing at the top of the market in 2007, when an ETF exposing you to a particular theme is issued, it’s a sure sign the fad is over.   

We have an LIC and ETF spreadsheet available on the Mar4cus Today website.

The most obvious LIC is AFI, although WAM has been doing very well. The most obvious ETFs over the market are the biggest – STW and VAS.

Finally:

The volatility is here, it is very likely to stay, you invest under the sword of Damocles at all times. If you are happy with an average return then there are LICs and ETFs and something like 4,000 managed funds that can achieve that for you, all of them have their sales spiel but they are fatally linked to averages because they are so diversified. And if you want to try and add a bit of value, try and trade an ASX listed fund, try and get the best bits and avoid the bad bits, you might just beat the averages.

Warning:

Its really boring. If you enjoy the stock market, trading a low volatility LIC or ETF is not for you...there's no action.

 

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