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Volatility is Our Friend By Stephen J. Butler

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"Everyone remain calm and nobody will get hurt." The classic command of armed robbers should be heeded by all of us with money in the stock market these days. Recent events have shown us how volatile the world of common stocks can be. It is reassuring, however, to know what can cause such sudden, wide swings in value that we have witnessed over the past month.

Let's take Tyco International, for example. Recently, its stock price dropped from $12 to $8 a share and rebounded to $12 all within the same day. What could have caused a company with almost 250,000 employees worldwide to lose a third of its value over a matter of hours? How can such a thing make any sense? Theoretically, stock prices are determined by efficient markets that reflect a consensus of a universe of investors. How could millions of investors suddenly have decided that Tyco deserved to take a momentary fall? It reminded me of that character in the play "A Thousand Clowns." Upon the command, "Die again, Mortimer," the actor reels around the stage and collapses with great theatrical effect.

There are two major factors that create volatility today. The first is the process by which all public companies are valued. They are valued by a process called "marking to market" which means that the entire company is valued based on the price obtained for the most recent share of stock that was sold. Apparently, in Tyco's case, someone started an unfounded rumor that the company was going to file for bankruptcy. Later in the day, Tyco announced that they had recruited a new CEO from Motorola with a track record of success. When the rumor started, nobody wanted to buy and the stock went into a free fall. For a short time on one day, the only people who were interested in buying Tyco stock only wanted to pay $8 a share. Later in the afternoon, others woke up and realized that an opportunity of a lifetime was taking place under their noses, and the resulting feeding frenzy drove the price back to $12 allowing those $8 buyers to make a quick 50% return?IN ONE DAY. The source of the rumor remains a mystery.

When a private company decides to make its stock available to the public, it gets in bed with the devil. Suddenly, changes in the company's value can hinge on events that can have little to do with the cash flow, profits, or general well being of the underlying organization. Instead, stock values can depend on such factors as an investing public and their Wall Street "servants" who are together preoccupied with their respective vacation plans right now. This leads to what has always been known as "the summer doldrums" on Wall Street and stocks generally become "thinly traded." When fewer stocks are traded, the marked-to-market mechanism for determining value generates more extreme volatility. The "marked to market" mechanism means that, in theory, even a few shares of Tyco stock changing hands at some price at the end of the day would determine the share price for all of Tyco at that moment. The last trade of the day determines the price we see the next morning in the paper. A thinly-traded stock leaves more room for market inefficiencies. The public markets work the best when stock prices are a reflection of the largest possible on-going auction.

A second component of inefficiency seems to be created by programmed trading. This is a tool used by major financial institutions to buy or sell broad-based blocks of many stocks all at once. A flood of these huge orders amounts to aiming a magnifying glass at the marked-to-market mechanism and accelerates the rising or falling price at which the trade ultimately takes place. Programmed trading in the past month represented 40% of the daily volume of the New York Stock Exchange, so it is a significant factor that bothers many people in the industry.

Programmed trading was invented during the early 1980's as a computerized mechanism for buying or selling stocks automatically when overall market performance signaled a need to move in either direction. To this day, there has been no clear explanation for why the 1987 crash took place, but some blame the severity on program trading that sent successive waves of computer-generated selling orders into markets where there was no one to buy. Fortunately, programmed trading works both ways and helps to explain the one-day gain of over 5% a few weeks ago.

In an effort to control a phenomenon that is not fully understood, the stock exchange now prohibits program trades whenever the market has experienced a downturn of at least 180 points of the Dow Jones. Generally speaking, a selling trade can only occur when the market is momentarily rising, thereby preventing a rapid, automated, downward spiral. This prohibition has been triggered six times so far this year.

It is possible that markets may not be as efficient as they once were now that small investors in the aggregate have turned to mutual funds. What was once a huge universe of individual investors has effectively become an institutional investor, and people like Warren Buffet now see this as a situation in which nobody is doing their homework anymore. Fund managers generally want to follow the herd and struggle to keep up with indexes. Many actively-managed funds these days have performance characteristics that effectively mirror the S&P 500 index. There is even a measurement tool, "r-squared," which measures the extent to which this happens. As Buffet said back in the '80's, "a growing number of investors have been taught that thinking is a waste of energy which just leads to greater inefficiencies."

I don't think it's reasonable to expect amateur investors to recognize inefficiencies, but we can keep our heads down, stick to the basics, and make this current market work for us. Many people will say that their best investment is their house and that they've always lost money in the market. That's because, unlike their stock investments, they kept making house payments and didn't panic when housing prices dipped.

The reason for exploring the causes of stock market volatility is to offer reassurance that the stock market will continue on as one of our most useful investment tools. Of all investment types, the stock market historically has proven to be the most profitable but only for those who had the fortitude to stay the course and earn the "risk premium." As investors, a portion of what we will enjoy as our long-term rate of return is attributable to our reward for the abuse we have experienced over the past two years. Meanwhile, today's environment offers some great buying opportunities for those who have long-term goals. Volatility and its downdrafts offer us some good hands-on practice with the tools of diversification and dollar-cost averaging.