Stocks dropped yesterday following epic gains just a day before. Bad economic numbers from China set off a chain of events that led 10-year Treasury Note yields to pandemic-era highs which only increased the selling pressure.
It’s all Greek to me. Any investment that can go up so aggressively in 1 day, surely has the potential to come down just as hard the next. My regular readers know that I often write that volatility works in both directions. The challenge is that most investors view oversized positive swings as reward for investment prowess…pro tip: it’s not, it is market volatility, and as good as it feels on the way up, it hurts that much more on the way down. You don’t have to guess just how volatile the market is, you can simply refer to the VIX Index to get a mostly objective numeric read. The VIX traded above 32 yesterday, up nearly +23% from Wednesday’s close. A VIX at that level implies daily moves on the S&P500 of almost 2%. For many years, moves of that magnitude would be considered outliers, not so much so in the past several months in which we have been experiencing extreme volatility. Yesterday’s drop was an outlier to even the outliers, with the S&P tumbling by -3.57%.
Beta is a measure of a stock’s volatility relative to the market. A stock with a Beta greater than 1 means that it is more volatile than the market, while a Beta less than 1 means that a stock is less volatile. Growth stocks are generally more volatile than the overall market as much of their success is based on hopes of great continued growth in the future. Those stocks would, as you might guess, most likely have Betas greater than 1. In a bull market, those high-Beta stocks outperform the market based on Beta alone. Of course, I am assuming that all other things are constant (ceteris paribus is the technical economics term for that). For example, if you just pick a handful of random stocks with Betas greater than 1 and the market experiences a bull run, AND none of the companies release bad press (that’s the ceteris paribus part), you will look and feel like a superstar portfolio manager. If you have been paying attention up until now, you are likely concluding that if the market tumbles you would feel, well… not great or successful at all. Alas, there is hope, and that hope is Alpha. Alpha is a measure of a stock’s return in excess of volatility, or Beta. I am oversimplifying this because too much math on a Friday morning is usually not well received. The concept works like this. Here comes the overly simplified math. You buy a stock that has a Beta of 1.5 and the market goes up by +1%, you would theoretically earn +1.5%. You have been paid to take on that volatility. If that same stock returns +2%, that excess +0.5% return comes from Alpha. You achieve Alpha by selecting a stock that continuously and consistently outperforms at the corporate level. This same basic concept can be applied to downward moves. If the market is down, your same stock will fall further than the market and your Alpha will theoretically lessen the loss. Now, I am sure that you are well aware that achieving consistent Alpha is very difficult and achieving it at the portfolio level (with multiple stocks) is even more challenging. If that is done correctly your portfolio would achieve greater returns than the market on the upside but realize losses less than the market on the downside. Even if you don’t know how to calculate your portfolio’s Beta, I am sure that, after the past 2 sessions, you know if you have a portfolio with a Beta that is greater or less than 1. Historically, the S&P500 returns around +10% per year on average, so even if you have not been able to achieve any Alpha on your high Beta portfolio, you will earn more than +10% per year on average. Those big positive periods will feel incredible, while the bad stages will sting…volatility works in both directions.
YESTERDAY’S MARKETS
Stocks fell yesterday as anxiety of the prior day’s Fed decision was digested. The S&P500 traded lower by -3.57%, the Dow Jones Industrial Average fell by -3.12%, the Nasdaq Composite Index dropped by -4.09%, and the Russell 2000 Index gave up -4.04%. Bonds declined and 10-year Treasury Note yields gained +10 basis points to 3.03%. Cryptos fell by -8.69% and Bitcoin lost -8.4%.
NXT UP