Barron’s picks up “Selloff Reawakens Market Volatility”

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After last week’s RR&A Market Letter on Volatility, I noticed that Barron’s Up and Down Wall Street Daily asked the precise question we addressed: Was That the Big One, or Just a Prelude?

So I emailed Randall Forsyth about our analysis ("Selloff Reawakens Market Volatility"), and Up and Down Wall Street picked up the piece. Here’s the excerpt they ran (along with some exceedingly kind words about TBP):

"WAS THAT THE BIG ONE,
or just a prelude? To that question — posed here following last
Tuesday’s 400-point hit to the Dow — the answer is the latter, if
historical trading patterns hold.

So says Barry Ritholtz, chief market strategist of
the eponymously named Ritholtz Research & Analytics. (In his spare
time, he also pens The Big Picture, a must-read blog at http://bigpicture.typepad.com/, and is a regular guest on financial television, where he tries to
provide a counterweight of rationality to the typical ravings heard
there.)

"When we see these -3% days, especially after a long
stretch of low volatility, it typically means volatility has returned
with a vengeance. We should expect to see both higher AND lower
prices," he writes in an e-mail.

"Consider 1997: From Oct. 16 to Oct. 24, the market
suffered three single days where prices were down between 2.5% to 3%.
The next trading day (Oct. 27), the Nasdaq dropped about 100 points
(-6.2%). The day after saw a gap down of another 75 points, but then
the market rallied, closing up over 9%! Some more upward progress was
followed by an 11% setback. The washed-out markets set up a 30% rally
by April 1998.

"A similar pattern occurred in 1998. April 6 and 7
saw 1.7% and 2% drops, respectively, followed by oversold conditions,
leading to a 10-day rally of about 7%. That set up some wild market
swings over the next six months: a 10.7% selloff, an 18.2% rally, a
27.2% selloff. From there, we saw a near 20% snapback, leading to a
23.6% correction, and by Oct. 8, 1998, the markets had erased the gains
for the entire year and then some. The deeply oversold conditions led
to a rally that was up about 60% by the end of 1998, and tagged an
86.7% gain on by Feb. 1, 1999.

"December 1999 and January 2000 saw several 3% down days. The market peaked on
March 10, and two days later suffered a 6% (peak-to-trough intraday)
whack. The next day was another hit of near 4%. These moves set 2000 up
for what would turn out to be one of the wildest years in market
history. From that March peak to the beginning of April, the Nasdaq
dropped 29%. A 22% bounce by April 10 was followed by a 27% drop, a 23%
gain and a 23% selloff. And that was all before May was over!

"From the lows in May, the Nasdaq subsequently
rallied 41% by mid-July. Between then and Sept. 1, the ‘Nazz’ dropped
17.9% and rallied 21.0%. From September to December, the Nasdaq markets
then dropped over 40%, to just about 2,300.

"Here we are nearly seven years later, and the
Nasdaq is less than 100 points above the levels of December 2000 — but
that’s another story entirely…."

So, what’s ahead? More volatility, as in those previous episodes, which usually follows a drop after a period of subdued volatility, says Ritholtz. The markets also typically attempt to revisit their old highs as psychology is "balanced between complacency and denial," but fail to do so.

Ultimately, deeply oversold conditions create great entry points as markets get oversold, Ritholtz says. But that means breaking below 200-day moving averages, which for the Nasdaq Composite is about 100 points under Monday’s close of 2340.68. In other words, considerably lower."

Forsyth looks at various ways to "cushion those bumps ahead." Given how tightly correlated "nearly every major asset class" has become, its increasingly difficult to find assets that are negatively correlated. The lockstep exists in Foreign stocks (the MSCI EAFE), small-caps (the
Russell 2000), even real estate, even gold and commodities. Given the difficulty in finding higher returns with less risk, its no wonder that hedge fund returns have been disappointing.

Amongst the few asset classes negatively correlated with stocks are bonds, T-bills, and cash. Citing research from Merrill Lynch chief strategist Richard Bernstein (and associate Kari Pinkernell), for the short-term, "cash remains the cheapest asset class around with a 5%-plus yield. And the safest."


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Source:
Fasten Your Seatbelts, It’s Going to Be a Bumpy Ride
RANDALL W. FORSYTH
UP AND DOWN WALL STREET DAILY
Barron’s, March 6, 2007 7:04 a.m.

http://online.barrons.com/article/SB117309378516026856.html

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Blame the professors: Just as the option backdating scandal started with academic researchers noting mathematical anomalies, so too might the next brewing scandal: the I/B/E/S Analyst ratings back dating scandal.

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