Recent Volatility ? Noise, not Signal

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Stocks and bonds reacted quite negatively to the latest testimony from Federal Reserve Chairman Ben Bernanke June 19. The S&P 500 indexdropped 3.8% on Wednesday and Thursday combined, while international equity markets fared even worse. The domestic bond market continued its selloff, with long-term bonds dropping 2.7% and emerging-market bonds sinking 4.1% in the same two-day period.

This spasm of volatility is a normal side effect when market participants adjust their positions to a new expectation for the future of monetary policy. Even though the policy adjustment being discussed at the Fed is minor – i.e., a gradual tapering of quantitative easing (QE) – the timing of the change was sooner than many investors expected, so trading volume jumped.

The collective activity of traders repositioning their portfolios can create self-reinforcing feedback loops of volatility in the markets. The majority of the volatility that occurs in asset markets is driven by interconnected feedback loops. So-called fundamentals like earnings, inflation and the economy account for less than 30% of the observed volatility in markets, according to extensive research on the subject.

It is easy to interpret big moves in the market as a signal of something important, when many times it’s just noise. The recent volatility in the asset markets is more noise than signal. Encourage investors to consider behaviors that fit with this outlook, such as:

  1. Accelerating the buy-in process for investors averaging-into the markets with cash.
  2. Adding to positions in the equity or fixed-income markets for investors sitting on excess cash.
  3. Considering longer-term bonds in the fixed income markets as a complement to a ladder of shorter maturities (i.e. looking at 4-7 year maturities with new cash, as opposed to 1-3 years).
  4. Not selling out of the equity markets right now.

Four developments hold clues as to whether my benign forecast might be wrong. They are:

  1. Inflation
  2. China
  3. Japan
  4. The eurozone

I will discuss each of these factors in brief below.