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Stock Market Volatility Is Not Risk

Companies / Corporate Earnings Apr 12, 2012 - 09:01 AM GMT

By: Charles_Carnevale


Best Financial Markets Analysis ArticleThis article was inspired by Roger Nusbaum's post on his Random Roger blog - Sunday Morning Coffee on Sunday, April 8, 2012. Roger is a highly respected financial blogger that I believe is genuinely interested in providing his readers meaningful and prudent investment advice and guidance. Therefore, I have a great deal of respect for his work and intentions. On the other hand, Roger and I often disagree on certain investing principles, especially those that deal with asset allocation, proper diversification and the definition of risk. However, I would hope that he respects my differing views as being offered with the same best of intentions, as I see his offerings.

The Greater Risk is People's Reaction to Volatility

Roger's blog dealt with his feelings about a recurring theme in Barron's over the weekend referencing people's complacency for risk. The first part of his writing dealt with the risks associated with the utilization of puts. On this subject, Roger and I are in agreement. However, the second part of his blog talked about what he obviously felt was the great risk of using dividend paying equities as an alternative investment choice. The following excerpt introduces his views, which frankly, up to this point, I take little exception to:

"The other point from Barron's (this was repeated in a couple of places) was a repeat of the idea that the Fed's interest rate policy (and the other attempts to stimulate the economy) are forcing investors into other instruments to seek a "reasonable return."

However, I do take exception to his next paragraph as I felt that it is overstating the risk associated with the utilization of dividend paying stocks for two primary reasons. First of all, his assumption that a bear market will provide a tragic outcome because dismayed investors will panic is more assumption than fact. Second, his last sentence insinuates, at least in my opinion, that dividend paying stocks are not safe investments.

"I hate this line of thinking. It would be great to get a "reasonable" rate of return from cash and treasuries but for now that is not the case. That people put what should be their low risk dollars into higher risk instruments to get a return they used to get from cash has tragic outcome written all over it. If there is another bear market before interest rates normalize there will be an avalanche of dismayed investors panic selling their dividend stocks because they thought the stocks were "safe."

But it was with the last couple of sentences of his blog post that I took the greatest exception. More precisely, I found that his example of Phillip Morris International (PM) to be misleading. However, not because of what Roger included, but rather because of what he left out. I will elaborate more right after the following excerpt where he closed out his blog post:

"All stocks have strong and weak holders and I promise you that the weak holders will sell into the face of something bad--this is normal market behavior and has nothing to do with the merits of a stock or a strategy. I believe a client holding Philip Morris Intl (PM) is favorably viewed by the dividend crowd yet it went down 32% from when it spun off in March 2008 into the March 2009 low--weak hands not bad stock."

It is certainly possible, and perhaps even probable that Roger is correct in assuming that so-called "weak holders" may in truth do as he suggests and panic sell. However, I believe a lot of that "normal market behavior" can greatly be attributed to the preponderance of negatively biased information that is promogulated upon the general public, especially regarding equities and how risky they are. In other words, if people were offered a more reasoned perspective, then perhaps much of the irrational and catastrophic panic selling that Roger alludes to could be avoided.

The following analysis utilizing the F.A.S.T. Graphs™ earnings and price correlated research tool on Philip Morris International illuminates the important parts that I feel Roger's comment left out. Roger is correct regarding how far that Philip Morris International's stock price dropped, as can be seen by reviewing the black monthly closing stock price line marked by the flags on the graph. Phillip Morris International's stock price did, in fact, fall by the 32% plus number that Roger presented, and as he also stated, can most likely be attributed to "weak hands." However, what his comment left out was the fact that the company's operating earnings were stable and continued to grow. More simply stated, the stock price fell even though the company's operating results remained strong and solid.

Therefore, investors armed with that information could have seen that this low point in Philip Morris International's stock price represented an incredible opportunity not a high risk. The smart money (strong hands) would have added to their positions in this high-quality company that was continuing to post good results and raised its dividend every year, rather than sell out. However, even if no one added money and simply held on they would have been given a substantial increase in their dividend each year and had their stock price rise from the original $50 a share to the more than $80 a share that it currently trades at (see flags on graph). The risk was not in the volatility itself, true risk would have been irrationally reacting to the volatility.

My point is that price volatility in itself is not risk, in my opinion, true risk is how people react to volatility when it occurs. Moreover, I believe that the reason there are so many "weak hands" is because of the weak information that investors are inundated with. Knowledge is power, and I believe that if people were provided with greater knowledge on how equities, especially dividend paying equities, truly work, then we would be cultivating a lot more strong hands. At the end of the day, this could also reduce the level of volatility by reducing the level of panic that would result from a better informed public.

Phillip Morris INT'L

Phillip Morris INT'L - 5 Year Performance

Risk, Diversification and Prudent Behavior

In an attempt to summarize my views on diversification and how they differ from Roger's I offer the following. The principles of proper diversification are both important and sound, and therefore should never be neglected when developing an asset allocation strategy. Moreover, the principles of proper diversification are valid and necessary when dealing with uncertain markets, but especially during times when markets are functioning (plus or minus) in a normal manner. Therefore, I am comfortable with and embrace a strategy of diversifying across numerous asset classes as long as each asset class makes sound and prudent economic sense at the time. However, when, and if, an asset class sits at an extreme level, then I feel it is imprudent to utilize it for the sole sake of so-called diversification.

I believe bonds of all types are currently sitting at such an extreme. Traditionally thought of as safe investments, I believe that over the next four or five years bond prices could show more downside volatility than equities did even during the great recession of 2008. Under normal times, bonds would offer yields that were several percentage points higher than quality dividend paying stocks. Consequently, bonds were attractive due to the higher level of income they offered and were relatively stable as long as interest rates remained within historical normal ranges. Today that is not true.

As a result, I currently eschew the asset class bonds in favor of high-quality blue-chip dividend paying stocks. To be clear, when bond yields move back to more normal levels I would once again be happy to embrace including them in a properly diversified asset allocation plan. But at today's low rates, I believe that the traditionally safe bond has become one of the riskier asset classes, especially if you consider the potential for high volatility with their prices as risk. My point is, my aversion to bonds is a temporary one that would change if and when interest rates normalize and stabilize.

Therefore, to mindlessly invest in an obviously dangerous asset class for the sole sake of diversification does not make sense to me. We believe that investors should always think their way through the process of allocating their assets when building their portfolios. On the other hand, I don't believe that money should be forced into an asset class when it doesn't make economic sense just because you hold the notion of diversification as sacred.

Diversification when properly applied is a great way to control risk. But investing in an asset class that is upside down solely for the purpose of diversification when it can be obviously avoided makes no sense to me. Technology stocks during the 1999 bubble were a case in point. All you had to do was run the numbers and you could have quickly determined that there was no economic value in technology stocks at that time.

In contrast, today when looking at quality blue-chip dividend paying stocks that are trading at historically low valuations thereby offering above-average and growing yields, makes a lot of sense to me. I would argue that because of historically low valuations, they have never been a safer investment choice than they are today. And, the only reason to consider a Dividend Aristocrat or a Dividend Champion, at least to my way of thinking, is because you intend to own it for a very, very long time. Therefore, you cannot avoid short to intermediate term volatility, nor should you try. Instead you should accept it as an unavoidable fact of the market. Otherwise, a record of increasing the dividends every year for 25 straight years or more doesn't really seem relevant, unless you were going to hold for many years.

Not All Price Drops are the Same

A final point I would like to introduce is the idea that not all price drops are the same. Sometimes the drop in a company's stock price is justified and the harbinger of real systemic issues. At other times, a drop in the price of a stock can represent an incredible opportunity to buy an excellent business that has unjustifiably gone on sale. Making these distinctions regarding volatility is a critical differentiation that should be made.

Furthermore, it's also valuable to be able to identify and determine whether an interruption of a company's business is a temporary one or a more permanent phenomenon. Because, there are times when the drop in price of a stock is a sell signal, and there are times when it represents an attractive buying opportunity. The following discussion is offered to illustrate examples of the many faces of stock price volatility to include the good, the bad and the ugly. These are just a few select examples, and there are many others that I could have used.

Bank of America an Ugly Price Drop

Our first example looks at Bank of America (BAC), and represents a quintessential example of an operating meltdown due to the now infamous financial crisis. Bank of America's stock price fell from a high of over $55 to a low of $2.53, which followed an earnings collapse from $4.65 in calendar year 2006 to a loss by calendar year 2009 (see red highlight at bottom of graph). Therefore, since both earnings and price collapsed, not only was the price drop justified, but the recovery may be years away, if ever. This is why I consider this an ugly price drop.

Bank of America

General Electric - a Bad Price Drop and an Ugly Price Drop

In the case of General Electric (GE), there are actually multiple variations of different kinds of price drops. First, we can see that in calendar year 2000 General Electric's stock price had become massively overvalued. Consequently, even though earnings continued to look good for several years, the falling prices in 2001 and 2002 were justified due to excessive valuation. Then, of course, we see a price drop where prices followed earnings down during the financial debacle in 2008 and 2009. In this case, recovery should be sooner than what we saw with Bank of America, although it still looks like it's still going to be many years away.

General Electric

Wells Fargo - a Bad Price Drop Getting Better

Wells Fargo & Co. (WFC) represents a financial that had a bad price drop that followed a similar drop in earnings. However, earnings have subsequently recovered and stock price recovery has already been good to the extent that it may soon eclipse historical highs.

Wells Fargo & Co

Cognizant Technology Solutions - A Good Price Drop

My last example looks at a company that had its stock price drop significantly during the great recession, while operating earnings continued to increase at a very strong rate. Consequently, this represents an example of a good price drop that created an extraordinary bargain. Therefore, price recovery has already dramatically exceeded historical highs (see price flags on graph).

Cognizant Tech Solutions

The point with this exercise was simply to illustrate that a drop in a company's stock price is not always a bad thing. Sometimes it is, as we saw with the Bank of America example, and sometimes it represents a great opportunity as illustrated by the Cognizant Technology Solutions' example. I believe that investors need to make these types of distinctions in order to truly be able to make sound and proper buy,sell or hold decisions. In other words, sometimes the price drop is justified and sometimes it's not.

Summary and Conclusions

As I mentioned in the opening of this article, it was inspired by comments that were made by a financial blogger that I respect. On the other hand, there was much about what he wrote that I disagreed with,and therefore, I felt compelled to offer my opposing views. On the other hand, I cannot argue with his position regarding weak or strong hands. It is true, that many investors, because they are ignorant of the facts, can and will panic during periods of market turbulence. However, what I disagreed with most was the fatalistic attitude surrounding the notion that equities were bad because investors would panic.

I once read a quote attributed to Bob Veres, a respected columnist for the financial planning community that at its essence summarizes my view. I offer it as a pseudo-quote because I maybe interjecting a little paraphrasing:

"the definition of an excellent investment advisor is one who possesses the courage and integrity to insist that his clients do what they should do, rather than what they want to do."

In my way of thinking, I believe it is our responsibility as professional financial advisors and bloggers to educate our clients and readers to factual and valid principles of sound investing practices. To suggest that it's a bad idea for investors to own equities only because you believe they will panic because their hands are weak, is not a valid recommendation, in my humble opinion. Instead, I believe it's incumbent upon us to offer the correct information and education that will prevent investors from behaving in irrational ways that could hurt their long-term investment results.

Furthermore, the bottom line is that I believe that equities, especially blue-chip dividend paying equities are being given a bad rap from this attitude by suggesting they are riskier than, in fact, they truly are. The truth is that blue-chip companies such as Procter & Gamble (PG), Johnson & Johnson (JNJ) and many others too numerous to mention, have long legacies spanning decades of operating excellence and increasing dividends. To classify them as risky investments based on simply the idea that pricing can be volatile, is in my way of thinking, an injustice.

If these blue-chip companies are purchased at reasonable valuations based on fundamentals, then the prudent investor can and should be capable of owning them over long periods of time. On the best ways to do this is to make the distinction between emotionally-driven price volatility versus permanent deterioration of the company's long-term fundamentals. As I stated before, both competent mountain climbers and Dividend Growth Investors recognize that the only way to get to the highest peak is to be willing to traverse the occasional valley along the way. We should not be telling investors that they are too dumb or weak-minded to own stocks, instead, we should be educating them on the true benefits and risks that come with owning them. Knowledge is power.

Disclosure: Long CTSH, PG at the time of writing.

By Chuck Carnevale

Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck is also co-founder of an investment management firm.  He has been working in the securities industry since 1970: he has been a partner with a private NYSE member firm, the President of a NASD firm, Vice President and Regional Marketing Director for a major AMEX listed company, and an Associate Vice President and Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

© 2012 Copyright Charles (Chuck) C. Carnevale - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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