July was not a good month for Canadian stocks. Let's get the numbers out of the way right now and then try to get our bearings: the TSX was down 6.04%, the materials sub-index was down 12.18%, the energy sub-index was down 13.00%, the TSX Venture was down 15.62% and the CRB Commodity Index had its WORST MONTH IN 28 YEARS! OK, now instead of rehashing last week's blog, "And the first one now will later be last, for the times they are a-changin' - Bob Dylan", where we talked about the disconnect that was occurring between commodities and commodity stocks and the recent outflow from commodity strategies into financials and other out-of-favor sectors, lets look at another piece of the puzzle, volatility. Volatility measurements attempt to quantify in percentage terms the movements in a stock price or index over a given period of time, usually a year. The higher the percentage, the more volatile the stock (or if you prefer, more risky), and vice versa. That said, volatility is something that investors have never really been able to get fully comfortable with. Let's take a look...
It is fairly straightforward that given a choice between two investments with comparable returns, investors will gravitate towards the less risky choice... this is commonly referred to as risk aversion. What is more difficult to quantify however, is how much volatility investors are willing to tolerate for given returns and how their tolerance changes over time in periods of increasing volatility (as a side note, the measure of volatility itself, typically standard deviation, is somewhat incomplete. Measuring past movements of a stock price tells us how volatile the stock has been in the past, not how volatile it's going to be in the future). If we look at charts of the materials and energy sub-indices on a year-to-date basis we see that the trend has generally been higher over the year, with gains of 10.3% and 8.0% respectively, and that compared to most other global indices (which are down anywhere between 15%-50%) the materials and energy stocks have had a fantastic performance, so why do we feel so uneasy? Well, notwithstanding this month's sharp pullback, the story behind the story is that the volatility within the stock markets, particularly the commodity stocks, has increased noticeably. Let's go to the charts...
5 YEAR MATERIALS SUB-INDEX VOLATILITY
(Black Line: 100 Day Moving average, Blue Line: 200 Day Moving Average)
5 YEAR ENERGY SUB-INDEX VOLATILITY
(Black Line: 100 Day Moving average, Blue Line: 200 Day Moving Average)
All right, so what are these charts telling us? In short, volatile sectors are becoming more volatile. The materials index ranged between 15% and 25% between August 2003 and November 2007, whereas now it sits at 37%, meaning that volatility has nearly DOUBLED. The energy index is similar although less severe thanks to hurricanes Katrina and Rita in late 2005. Nonetheless, volatility on the energy index has moved from 18% in November 2007 to its current rate of 28%... a gain of close to 60%. The TSX itself has moved from 12% volatility last summer to its present level of close to 20%. The Shanghai index has moved from 21% in late 2006 to its current rate of 43%! So there you have it. The reason investors aren't able to sleep at night is not just that their portfolios have declined, but that the back and forth movements have become for more volatile, and perhaps most importantly, the perceived chances of a sharp decline in value have increased greatly... and that makes us uncomfortable. Historically, these surges in volatility presage a change in sector leadership within the market. While we have written in the past that we're cautious on commodity stocks these days (see Oil UP, Natural Gas UP, Energy Stocks DOWN... HUH??) we continue to like the sector in the medium and longer terms. In the meantime, we'll continue doing what we've been doing: reducing exposure to the market in general (holding cash), reducing exposure to commodity sectors, and looking for opportunistic trades (both on the long and short sides). With some luck, volatility will be reduced in the coming weeks, markets will get back to 'normal' and we'll enter the dog days of summer, like we normally do at this time of year.
Wake me in September
In other news...
This September marks the 20 year anniversary of Ben Johnson's spectacular rise to the apex of the sprinting world with his world-record setting, gold medal victory at the Seoul Summer Olympics. If you find yourself feeling a little less than enthused about the upcoming Beijing Olympics, it seems you're not alone. And if you're fearful about the rise of China onto the global political and economic stage, consider this; according to the online gaming site Bodog, China is now the (narrow) odds-on-favorite to win the most medals at the upcoming games. The times they are a-changin'... indeed.