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Volatility: Good Thing for Strong Stomaches

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By PaulEngr
May 29, 2008

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I don't see what the problem with high volatility is. On the other hand, I don't see it getting better any time soon and I don't know whether it's good or bad. It's just...different.

I can see the problem from a fund manager's point of view. Since at this point managed funds are all starting to look like clones of the S&P 500 index, and they get beat up if they increase/decrease precipitously, well, no surprise there.

Folks, we're not in a recession, and the GDP reports (to say nothing of a lot of others) support it. It has been made far worse by a bunch of stupid moves by those with political motives. So we're in for a ride now for probably another 12-24 months. I can't help it if absolutely everyone on the evening news says we're in a recession, and their saying it doesn't make it so. The only people squealing like pigs are the ones that were in a market that was clearly atrociously overvalued, such as real estate. Any time now we're likely to see the same thing happen in the energy market. The only thing that is not certain is just when the bubble will burst.

What is definitely happening is that regardless of any bubble, there has been a fundamental shift in the economics surrounding energy. Even if oil dropped back down to pre-bubble levels, it doesn't matter. Any time that you have a sustained price increase for a long enough period of time, you cause changes in market forces. New doors get opened as consumers (corporate and individual) struggle to find alternative products. Once that shift starts happening, even if everything returns to "normal", it can never be normal again. The door has already opened.

In the mean time, we have all this chaotic response. It's still a random walk down Wall Street, but it's more like a drunken stupor. And it too is easily explained. There's a theory that David Dreman (among others) floated supported by lots of data that when stocks are trading at a premium, when they finally do take a dip, it's much more significant than any increases. Conversely, the same thing happens near the bottom.

Right now we have every member of the press talking recession in spite of the economic indicators. So stocks took a nose dive purely on the word of the press. Except for what's happening in the energy, housing, and mortgage markets, there is simply no change in the fundamentals. There's some spill-over, but no fundamental shifts.

One of the interesting quandaries is that for instance with mortgages, it's the same problem I've been complaining about for years. Unlike manufacturing, the GAAP rules simply don't do a good job of providing any sort of transparency with financial companies. The result is that you can NEVER really get a good grasp of what a financial institution's condition truly is. I've reacted to this by simply not investing in them and clearly it served me well over the past couple years. Now that lack of transparency has become a huge problem because we know that there's still a lot of bad money floating out there but now everyone is recognizing that there's no way to discern who is holding it. So you have severe and deserving volatility and some very depressed stocks. If and when the financial institutions finally accept the idea of transparency and allow GAAP rules to take effect that publish their default rates and/or their anticipated default rates, that's when we'll start to see some large increases in the value of those stocks.

So stocks took a nose dive purely on speculation and fear. Some (banking and real estate) deserving and some not. By Dreman's theory, you'd EXPECT them to jump more than just a little bit on any possible news or speculation. Now we're getting more and more economic news and again, speculators are jumping for no particularly good reason.

In addition, there's this big energy question. It's pretty clear that everyone is being affected. The trouble is that very few companies have a good grasp on what this means for the future. They have no really clear way to predict what is happening to them. You know shipping costs are going up, but by how much? So how do you price your product to accommodate it? You know your fuel costs are going up, but since there are so many different influences at play, how much? Nobody knows, so almost everyone is just speculating and riding the waves. I don't think any company in the country right now has a budget that is worth anything other than outhouse paper as a result. So no budgets, no planning, short or long term. So when the CEO makes predictions in the quarterly reports, we all know they are just words filling up space on a piece of paper.

All this results in stocks going absolutely nuts. At this point we're ALL speculators. Even those who watch the fundamentals don't even know what the fundamentals are anymore.

But it has caused some absolutely amazing things. I bought stocks I wouldn't even consider at prices that I wouldn't dream of seeing over the last 6 months, and then sold some of them for the exact same reasons! Have market fundamentals changed? Nope. It's just that the stocks are all bouncing around like yo-yo's. I'm buying and selling on fundamentals. I don't have any confidence that I'm right anymore. All I know is that I'm averaging double digit returns on virtually everything in 6 months that normally takes 2-3 years for the same kind of thing to happen.

So keep 'em on bouncing! I for one have not been disappointed yet. I have just two out of about a dozen stocks that are still way down relatively speaking (double digits down). Both were bought in deep value territory and both were falling knives. So I expected it. And I plan on holding onto them for at least another couple years. If the speculators want to drive the prices up to double digit gains in 1/4 of that time, go for it! I'll be happy to sell once they hit the overvalued territory. I'll be more than happy to do my part in soaking the speculators for their folly.

I have several more that I believe just haven't quite made their move yet back to fundamentals yet. For instance, MMM. It's normally a "widows and orphans" stock. It just predictably churns out cash, year after year. You just can't buy it for the kind of money that it's been selling at. So I sit and wait. I don't think I'll be waiting too long. Or as I said...perhaps all our ideas about fundamentals are all wet at this point. In which case I still think MMM is going to go up, but perhaps not as much as I suspect. I'll know better once we get a little bit of stability in the energy market. But that's at least another year or two away.