Happy New Year! The new year will be a lot like an old year. Not 2012, but quite likely a lot like 2011, marked by increasing volatility and possibly a correction, before we begin a new leg higher in the markets. I reserve the right to be off by a year, but given a host of reasons covered in my year opening article for MarketWatch - Prepare for Zero Real Growth in the U.S. in 2013 (please read it) - it is time to err on the side of caution again as other investors decide to get back into the markets after several years.
When I discuss volatility, many people react with disgust or disjointed irritation about what they perceive as a high level of volatility in the markets. Over the past fourteen years there has certainly been volatility, but in the past year, volatility has been very low. Most people are not aware of this.
In 2011, we saw the year begin with a low volatility uptrend, see volatility spike into a correction, then volatility diminish and support another rally. As I discussed on MarketWatch the first week of January 2012, Your Major Risk in 2012 is Missing the Upside, I believed 2012 would be a pretty good year despite common perceptions that market volatility was a major risk.
Today, now that the Mayan calendar has recycled and we have survived, let's take another look at volatility.
Let's start with something fresh from Warren Buffett's 1993 letter to Berkshire Hathaway investors:
“In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That’s true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.”
So, the world's greatest investor is telling us to use volatility to our advantage. We can do this through buying good assets when the markets make those assets cheap and also selling when the market prices assets higher than their value implies from time to time.
As has been the case historically, the market generally makes many stocks cheap at the same time. This is called correlation. Often, entire sectors fall at the same time, only to later rebound as a group. In these situations, we might invest in an entire sector using an exchange traded fund (ETF) or via buying several stocks in the group. Last year on Motley Fool I discussed how to Build Your Own Bakken ETF when I identified that Williston Basin North Dakota oil stocks were good long-term holdings.
Recently, most of the stock market has risen in a highly correlated low volatility way. As a result, very recently, small investors have started to add money to the stock market for a the first time in a long time. This phenomona of small investors getting into the market after a large run-up, you have noticed the market roughly doubled off of it's 2009 bottom haven't you, is known as "ImMissingItitis." It's a psychological disease.
The symptoms of this disease can be very devastating. The first symptom is marked by night sweats and irritation after hearing how their friend or neighbor made money in the stock market recently. After stewing for awhile and watching the market continue to go up, the patient calls their advisor or broker, or worse yet, logs onto their formerly dormant online brokerage account. What happens next is ugly - the patient orders their financial person to get more aggressive or starts clicking away firing off buy orders in their portfolio so that they can feel good again.
Inevitably the stock market falls again, generally to below the point where the patient has bought back in. The patient, who needs self-validation (the strongest human emotion), does not sell until they decide the market is rigged. The patient then blames others for their poor results and swears to never invest again. What they do not realize is that they never invested in the first place.
ImMissingItitis is a disease with no cure. Like many diseases, it only has treatment. Without treatment, the patient can lose most of their money and never recover. Effective treatment includes ignoring the noise, controlling emotions, patience, continuing to set aside money for future investments, learning to value assets and having the courage of conviction. The side effects of treatment are many; including self-doubt, lack of confidence, sweaty palms, weak knees and dry mouth. The medicine, like a kiss from mom, does eventually work however.
For 2013, as the year progresses, especially in January, we can expect old investors to become new investors, big investors to sell to small investors and governments to continue their slow dance of nincompoopery. We should also expect an eventual increase in volatility. We should not be suprised if the stock market, either this year or next, falls 20% to 30%. We should be prepared for that eventuality.
Here I will note something that is very important. We should not probably expect another financial armageddon. We already had it. Remember 2008? That was it.
The world is now very slowly, in fits and bursts marked with setbacks, getting better. Technology has unlocked and created new energy. Agriculture is poised to expand capacity. Debts are slowly getting paid. Getting better will come with some price on the calendar, however, in a several years, the world will be noticably better.
As investors, we will use 2013, and possibly 2014, to continue with our plan to focus on scarcity based investments which we can derive income and growth from, i.e. energy, alternative energy, water and waste infrastructure, agriculture, other various resources, medicines and basic goods as the world transitions to a more sustainable economic model over the next generation. As many of those types of investments are highly likely to be volatile on short-term cyclical economic news, i.e. a recession, we will employ volatility to our advantage.
Your forward looking advisor,