By JACK HOUGH
If U.S. stocks typically return 7% a year after inflation as history suggests, then shareholders lost one and a half years' worth of reward in just three days ended Monday. Late Tuesday, they secured nearly a year's return in an hour and 15 minutes. On Wednesday, they gave back more than half a year.
That's a call to action for investors, as I'll explain in a moment.
Advisers say not to worry -- that the market is often flaky in the short term but has been reliable over the long term. There's even comforting statistical evidence that the past week was a mere turbulence patch on an otherwise smooth flight. The Chicago Board Options Exchange Market Volatility Index, or VIX, uses options prices to measure how franticly stocks are expected to swing, up or down, over the next 30 days. It's high now. It was also high following the May 2010 "flash crash" and it hit a record high shortly after the September 2008 fall of Lehman Brothers. But it has also had long low stretches outside these spikes, so the average reading works out to no big whoop.
Researchers from UNC Chapel Hill argue otherwise in a new paper. What matters more than average volatility, write Gregory Brown and William Waller, is something traders have taken to calling vol-vol. It's the volatility of volatility itself. Think of it: A person with bipolar disorder swings from elevated moods to depression, over and again. Doctors don't say of such a person that his average mood is normal. They say he's sick. Likewise, the stock market's average volatility is less important than whether its fits are occurring more frequently. They are. Short-term instability (the term Brown and Waller use for vol-vol) has tripled over the past 40 years.
Joe and Sally Saver know this too well, of course. Their 401(k) hadn't fully recovered from the subprime crisis when it was whacked this week by the fiscal flop, or whatever this downturn will eventually be called. The stock market just doesn't seem as reliable as it used to be.
"Savers need to reconsider who should be invested in stocks and how much they should hold," says Brown. He's no doomsayer, but he's cautious. At 43, he has 40% of his money in stocks, even though financial planners typically recommend 60% for someone his age. One sign that worries Brown is that the total value of the U.S. stock market has increased much faster than the size of the economy, as measured by gross domestic product (see chart below). Another is that "there are many more speculative companies in the market today than in the past."
Stocks are getting riskier, but why? Bad news alone would explain the plunges, but not the equally sharp rebounds. In their paper, Brown and Waller note a baby boomer effect. Stock market participation rose from 19% of households in 1983 to 51% in 2007, and surveys show that willingness to take on risk increased steadily during the 1980s and 1990s. Perhaps Boomers got hooked on stocks back then when yearly returns averaged more than 13% after inflation and today remain eager to buy on any downturn.
I have another theory. Policy makers are pulling stock prices in opposite directions.
Government spending over the past decade worked like a credit card advance on growth. GDP per person increased 5%, but if we subtract for the increase in national debt, it shrank 6%, according to Robert Arnott of Research Affiliates. Politics don't matter here. The U.S. will have a balanced budget in 10 years because it will have to, wrote Arnott in a recent note to clients. What's good for the nation isn't necessarily good for stocks in the near term. That's why a recent rating downgrade for U.S. Treasurys sent their prices higher and those for stocks sharply lower. Stocks are being pulled lower by the public's suspicion that austerity is coming and that it will stink for near-term growth.
The upward pull has come from the Federal Reserve holding core interest rates near zero since December 2008, and it tugged again Tuesday, when it said rates will remain this low until mid-2013. The Fed is telling Joe and Sally to invest in ABC -- anything but cash. If savers buy assets like stocks and houses, pushing prices higher, they offset declines brought by the excesses of borrowers, and perhaps inject confidence into the economy, the thinking goes.
The Fed will ultimately lose this tug-of-war, Japan's recent experience suggests. Shares there have been in a funk for two decades despite low interest rates. There's no reason to exit stocks altogether, but Brown's conservative 40% allocation is probably a good goal for worried investors who find themselves all-in. Cash returns next to nothing, but then again, it has gained around 15% this month in terms of its stock-buying power.
For stock pickers, two things matter easily as much as low price-to-earnings ratios right now. The first is a company's ability to sustain its income if the economy stalls. Think peanut butter and medicine, not cars and posh vacations. The second is a company's ability to pay healthy and rising dividends. If share prices slip, dividends can be reinvested to create a growing stream of income, which eventually becomes more important than gains. Without dividends, shareholders can only hope that the market's next sudden mood swing is a happy one.