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How to Tell When Market Volatility Ends

While no one should time the market, there are ways for advisors to figure out when choppy equity markets are calming down.

By: VIKRAM BARHAT

Date: May 20, 2016

The first quarter was not a pleasant one for most investors and advisors. It was one of the more volatile periods stocks have experienced in a while, with most major markets falling into correction territory in January, only to bounce back in mid-February and March.

Of course, periodic corrections are a normal part of stock market cycles, but for savvy advisors they also spell opportunity. The ones who buy in on the dip can see good gains on the rebound. But how can one tell when a correction is ending? While no one should time the market, there are ways for advisors to tell when things are calming down.

Keep and eye on sentiment

It’s actually reasonably straight forward to tell when a correction has run its course, says Jurrien Timmer, director of global macro at Fidelity Investments. It comes down to market sentiment.

“When the market is oversold, there are negative headlines in the newspapers and clients start calling their investment advisors,” he says, noting these are signals that investors are exiting. Investors can look at various sentiment-related trends and indicators for clues.

One indicator is moving averages, says Sam Stovall, managing director and U.S. equity strategy at S&P Global Market Intelligence in New York.

“When the market goes below its 10-month moving average, get out, and when it goes back above its 10-month moving average, get back in,” he says. “Looking at volatility and the panic in the market can frequently get you back into to the market pretty close to where the bottom is.”

He adds that it’s important to make a distinction between pullbacks and corrections. A pullback is a decline of between 5 percent and 10 percent, while correction is a decline of 10 percent to 20 percent. A bear market is a decline of 20 percent or more. How an investor reacts will depend on the drop and the speed of the fall, he says.

Not surprisingly, investors become increasingly nervous the deeper the decline goes.

“Then they compound things by selling mostly at the most inopportune time,” he adds.

Understand where the volatility is coming from

Something else to look at is the source of volatility, which could vary depending on global economic and financial contexts. Over the past year or so, the main cause of volatility has been the strength in the U.S. dollar, says Mr. Timmer.

“When the U.S. dollar goes up or down, it eases or tightens financial conditions,” he says. “And as financial conditions ease, volatility comes down. We’ve seen a very clear correlation where spikes in the dollar create more volatility in the market.”

Fund flows, the value of the Chinese yuan, which is loosely pegged to the dollar, the 10-year treasury and credit spreads, are some of the indicators that speak to whether a market is turning around, says Mr. Timmer.

“When they all moving in tandem, that can confirm a decline in volatility,” he says. “That gives me confidence that the [market] turn is real as opposed to some short-term noise.”

In today’s market, all indications point to that January correction as being a thing of the past. Oil is up about 50 percent since January, the Canadian dollar’s strengthening and credit spreads are narrowing.

“The markets have turned a corner at least from a short-term perspective,” says Mr. Timmer.

Look at history

Mr. Stovall points to history as a sign that the start-of-the-year volatility may be over, at least for now.

On average declines of 5 percent to 10 percent have typically taken less than two months to breakeven. Declines of 10 percent to 20 percent have taken about four months. The S&P/TSX Composite Index, which fell by nearly 10 percent between January 1 and 20, regained its losses a month and a half later and is now up 6.5 percent on the year.

If you are watching market volatility, you still can’t forget the basic rule of investing: stay focused on the long-term. While you do want to buy on dips, you don’t want to get caught timing the market.

Mr. Stovall cautions that these trend indicators are more a windsock than a crystal ball.

“If there was an ideal technique, then nobody would be willing to share it with you,” he says.

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