Special Investing Report: How hot is it?

The ups and downs of market volatility.

The market ups and downs lately rival the most stomach-churning of roller-coaster rides. The S&P/TSX composite index slid 222 points one day (Aug. 28), only to jump 225 points the next—in a pattern that’s been repeated more than a few times this summer. But while markets are now at their most volatile since early 2003, they are nowhere near as turbulent as they have been in the past. And like a roller-coaster ride, volatility isn’t always as scary as it appears at first glance.

Jason Goepfert, president and CEO of Sundial Capital Research Inc., a Minneapolis-based research and investment firm, points out that on Aug. 8 the historical volatility of the Dow Jones industrial average jumped to more than 20%, marking the first time in more than 1,000 trading days—1,077, to be exact—that volatility has been that high. (The benchmark 20% figure means that if the index kept up with the trend, it would close a year from now at 20% above or below its current level.) “What’s really been unusual is how stable the markets have been over the past three years,” says Goepfert. He adds that in only six other periods has the Dow had such long periods of stability—1946, 1955, 1962, 1970, 1980 and 1997. And what happened for each of those periods after the market finally turned more volatile? The Dow “dropped for a couple of weeks, then tacked on gains of between 10% and 20% over the next few months,” says Goepfert.

History, he adds, suggests that the occasional period of high volatility might actually be a good thing, “at least when looking at the intermediate-term returns—say, the three to four months following a bottoming of the market.” For the short term, “it might be time to put some money to work,” but he notes that for many investors that’s easier said than done. “The best buying opportunities are often when it’s most uncomfortable to do so,” Goepfert says. “And that’s the point, isn’t it? Because a lot of those buying opportunities go hand-in-hand with those volatile swings of 1% or more in either direction.”

Andy Engel, senior research analyst and portfolio manager at Leuthold Group in Minneapolis, agrees. A high volatility reading occurs near stock market bottoms, he says, and has typically “marked a good time to buy stocks.” Leuthold has for the past 20 years used the volatility index as a tool for looking at major trends, and high volatility is a “strong and effective” Buy signal.

To show what he means, Engel points to seven periods since October 1987when the 20-day moving average of the Chicago Volatility Index, a key measure of market expectations of near-term volatility in the S&P 500, broke above the 35 level. In five of those periods, the six-month performance rate rose, between 3.4% and 28.8%, while the other two periods saw a decrease of 3.7% and 8%. The average for all periods was an 8% increase.

Engel agrees that current volatility is in stark contrast to how stable the market has been recently. For example, in 2004, 2005 and 2006, between 12% and 16% of trading days on the S&P 500 were “high volatility days,” with moves (up or down) of 1% or more. In 2000, 2001, 2002 and 2003, the number of trading days with swings of 1% or more ranged from 32% (2003) to 50% (2002). Through the end of August this year, 22% of all trading days have been high-volatility. And in August alone, 52% of trading days saw swings greater than 1%.

Still, Engel points out that the figure through August is only slightly above the 20.7% median for the S&P, or the Dow prior to 1928, going back to 1900. However, he figures the volatility will continue for the next eight to 10 months, to the downside.

Ultimately, Engel says volatility makes for a better market. “It washes away unreasonable bullishness,” he adds. “It’s like having a healthy debate. The more closely investors have to look at the numbers and stake out their positions, the healthier markets will be at the end.” In fact, says Engel, “the time to be most worried is when things are too stable, and investors are too complacent.”