Recent Market Volatility Noteworthy After Two Quiet Years

The pros on Wall Street call it “volatility.” But the rest of us might just say “bouncing around,” as in, “The stock market ‘sure is bouncing around!”’

In the last few weeks, the market has made some stunning moves - down 297 points between March 26 and 31, down 148 points April 11, up 135 points on the 15th, up 173 points on the 22nd, up 179 points last Tuesday, up another 95 points last Friday, up 143 points again on Monday, then down 139 points Wednesday.

It’s worth noting, now that the Dow is around 7,000, that moves of a hundred or more points don’t mean as much on a percentage basis as they did when the Dow was at 3,000.

But the fact is, the Dow “has” been unusually volatile - even when viewed on a percentage basis. In the seven weeks since March 11, when the Dow set its last record, there have been seven trading sessions with moves of more than two percentage points up or down. There were no daily moves that large between Jan. 1 and March 11, and only three that large in all of 1996.

But 1996 - and 1995 - were years of unusually low volatility, making 1997 seem more radical than it really is, says David Blitzer, chief economist at Standard & Poor’s.

“I would not see this as a cause for panic or anything,” he said last week. “I guess, most of all, it’s a reminder that ‘95 and ‘96 were not average years, and this one is probably a little closer to average.”

Charles Pradilla, chief investment strategist for Cowen & Co., a New York brokerage, says the current volatility is caused in part by stocks’ unusually high prices. The average S&P 500 stock is trading at a price of about 20 times the company’s annual earnings, compared to a historical average of about 14 times earnings.

The higher the price/earnings ratio, the more radically the price will swing with real or anticipated changes in inflation. To see the connection, think of earnings as being a percentage of price, just as dividend payments or savings account interest is seen as a percentage of the amount invested.

Imagine you owned a stock selling for $100 a share, with earnings of $2 a share. That would give you a P/E of 50, which is very high. Your $2 in earnings would be a yield of only 2 percent. If inflation went up 2 percent, it would effectively wipe out your earnings, so you’d see any inflation increase as a serious threat.

But suppose you had a stock selling for $20 a share and earning $2. That would be a low P/E of 10, or a yield of 10 percent. A 2-point uptick in inflation wouldn’t be as threatening.

For the 50 P/E stock to maintain a real, after-inflation return of 2 percent, the before-inflation yield would have to grow to 4 percent. So earnings would have to double to $4, or the stock price would have to fall by half to $50. Either way, a dramatic move.

But the 10 P/E stock would not need such a severe move to keep up with inflation. It would have to increase its yield to 12 percent. It could do that by increasing earnings to $2.40, which is just a 20 percent increase from $2. Or the stock price would have to fall to $16.67 - the level at which its $2 in earnings gives a 12 percent return. That’s a drop of just 16.7 percent.

With P/E ratios high this year, heightened speculation about rising inflation is causing a lot of volatility in stock prices.

How should the small investor react?

The natural reaction is to get anxious, but the sensible course is to stay calm. When the Dow dropped 9.7 percent from March 11 to April 11, one might easily have felt it was time to head for the hills. But if you had, you’d have missed the 10.6 percent rebound over the next three weeks.

The Dow is up 9.66 percent in the first four months of the year - already a better return than you can get in an entire year in a government bond or a money market fund.