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Up the stairs, down the lift

One of the steps towards investing success is throwing off the tyranny of “should”. The market should go up, should go down, should trade sideways. The reality is that the market rarely does what it should, at least in the short term. When investors pay attention to market action, rather than their expectations, they tend to make faster and more profitable decisions.

Real market behaviour is often expressed in old market sayings. “The trend is your friend” and “buy the rumour, sell the fact” are well known, and widely understood. A less well explored market characteristic is “share markets go up the stairs, but come down in the lift”.

This observation is easy to verify by looking at a long term chart of almost any share market index. Bull markets often look like a steady build. Three steps forward, one back, up the staircase. This is a stark contrast to many bear markets. Sell-offs tend to be sharp and implosive, with larger daily ranges and bigger price moves.

The chart of the Australia 200 index with the Average True Range indicator (ATR) illustrates the effect. The sharp sell down in February this year saw the average daily range increase from below 50 index points per day to above 80 points per day. Some professional investors take advantage of this bear market increase in volatility. As volatility goes up when shares go down instruments that are sensitive to changes in volatility (options, convertible bonds, swaps, etc) can act as a hedge for share portfolios.

The reverse also generally holds. The ATR declined during the steady climb of the index from September to January. However recently the ATR has started to climb again, despite recent gains for the index. This uncharacteristic market behaviour is flashing a warning to investors.

By definition an increase in volatility means the index is less stable. This may reflect the more ambiguous investment environment. While global economic growth is clearly positive at the moment the potential for higher interest rates that accompanies that growth makes predicting market moves more difficult. Investors can become more reactive to the market action, as well as extraneous factors like possible trade disruption, exacerbating volatility.

The Australia 200 break through ten year highs is a positive development. However the increase in volatility suggests share market risk is also rising. Investors can deal with these changing market conditions in a number of ways.

Individual stock performance was a key determinant of investor returns over the last financial year. This is likely to continue. The first step for many investors is to examine the stocks that make up their portfolio. Higher growth stocks, with higher valuations, are a likely source of future volatility. Investors seeking stable returns and less worries may move away from technology stocks and market darlings such as CSL and A2 Milk.

Investors looking to juice up returns may take an entirely different approach. These same higher growth stocks are often badly affected in a sell-off. Investors who are confident in the positive overall economic outlook could look to take advantage, keeping cash on the sidelines, ready to jump.

Last week’s action is illustrative. Stocks fell for two days as investors worried about the impact of increased trade barriers. The turnaround came very quickly. Investors who didn’t act on the sell down missed out. The market conditions could see active investment strategies deliver the best returns over the coming year.

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