volatilityThere are a lot of experts giving their reasoning behind the extreme investment market volatility of the last few days.  In this regard, it is good to remind ourselves how investment markets actually operate and understand The Reality of Stock Market Volatility.

Daily market gyrations to this extreme, whether up or down, are principally based on sentiment and not value.  They are extreme trading-driven outcomes that depend solely on supply-demand imbalances throughout the day.  In large-volume, large capitalization stocks, the extreme prices you see (ie. the bottom of the trading range, and the top of the trading range) are most often the result of computer-traded and matched prices that are out of reach for the average investor.  In general, these are pro-trading executions that are making and losing money for professional firms who are active in the market every nano-second of the trading day.  The average investor is taken along for the ride and must endure it in this very short-term trading horizon.

Of course, in smaller cap, less actively traded stocks, this is not necessarily the case.  However, the sentiment expressed through the trading of active stocks feeds through to the market prices for this segment of the trading market also.

This goes back to the difference between price and value, and how short term trading prices are more a reflection of sentiment (driven by exogenous news, beliefs, and emotions), whereas long term prices are driven by value (being cash flow, asset values, earnings, sales, management talent, and so on).

Pundits who today have argued that the short term market volatility is an outcome of the loose monetary policy of the last few years that is coming home to roost, then, are way off the mark.  For one, ‘loose monetary policy’ has not fed through to the real economy in any material way – rather it has been captured at the big financial institution level (banks, insurance companies) and generally stayed there.  Just ask any small business owner if their access to capital (loans from banks, for example) has improved much over the last few years and you get an emphatic ‘no’.  This is why there are only a few economies in the world performing reasonably well and why employment markets (ex those of the U.S.) are still in recovery mode.

‘Loose monetary policy’ stabilized the banks in the liquidity crisis of 2008 (a necessary and effective policy move), but such a policy is not inductive to long term economic performance of firms unless it reaches down to them.  Such a policy is reflected in their equity valuations principally to the extent that it instills stability into their operating environment.

As for the pundits who shout ‘I told you so’ and boast about their unique investing foresight, these tend to be individuals who adore the attention and like patting themselves on the back.  Every investor and market follower can at some point use the phrase ‘I told you so’ – it just becomes a matter of when.  Every trade involves a buyer and a seller, so when there are massive sellers there are also massive buyers.

Those who can, and do, take advantage of extreme equity market volatility are traders in stocks.  Long term investors can use this volatility to trade around their core, value-driven investment positions.  However, this requires access to capital to execute.  And, of course, this is a risky strategy that produces both winners and losers, but it is the principal way to take advantage of volatility.

In assessing the overall situation, value investors need to ask themselves if this volatility (driven by sentiment) is sending a message about underlying economic fundamentals over the longer term that will affect the economic performance of their holdings (ie. their cash flow, earnings, sales, etc.).  In this regard, for example, a focus on China and its weakening economy may be the real worry for the future.  Assess what, if any, impact this trend and others will have on your preferred investments and make a rationale decision from there.