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A Return to Volatility or Not?

S&P 500 Index 20-yearsDouble click any image for a full sized view

There was a recent report from one of the Wall Street banks saying that the current volatility in the markets is a new phenomenon and that for the balance of the year investors should expect to experience more of it.

I’ll take the under on the first part of that statement.

Over the past 20 years, we have had similar volatility until just recently, so in effect the current bit of volatility is really a return to normal market action.  If you look at the graph above  you can see that the current volatility in the market started in the summer of last year, after roughly three years of calm upward movement in the market.  Prior to the fall of 2012, the graph shows similar volatility during its bigger secular bull and bear moves back to 1996.

As for the balance of the year, I agree that the markets will continue with the current level of volatility, albeit in a downward direction.  In the two most recent blog posts that I wrote, I discuss this very thing.  To summarize those posts, the intermediate to long term direction of the market is down and investors need to have a defensive asset mix including a healthy allocation to cash so that when there are short-term movements up or down within the major trend, they can use it for trading purposes.

If investors are not comfortable with trading for short-term gains, then buying a bond fund has historically acted as a hedge against major market crashes.  Here are a couple of graphs depicting how stocks and bonds trade in near mirror image, this first one shows the Dot Com boom and bust:

S&P V Bonds - NASDAQ Crash

and this second one shows the Subprime Mortgage crash:

S&P V Bonds - Subprime Crash

The downside with the bond fund is that if the Fed really gets into interest rate hiking mode, the bond funds will go down in value commensurate with the size of the rate hikes and the duration of the fund.

However, if the market crashes (and it is always possible given the risks to the financial markets that are out there) then a high quality US Treasury fund will be the best investment imaginable.   Since US economic activity is pretty tepid, there is little chance of significant rate increases in the near future, so booking profits in your stock portfolio (or stock mutual funds) and buying a high quality US Treasury Fund plays the percentages pretty well.

Why do I mention crashes?  Well, a lot of smart investors are already talking about it.  One is Carl Icahn whose hedge fund is 150% net short.  He is on record of stating that the market has a greater change of going down 20% than going up 20%.  Carl may or may not be right, but having some protection for your portfolio and structuring it in a defensive manner when the market is near an all-time high with falling earnings and poor technicals seems to be the prudent thing at the present time instead of swimming against the tide.