Last week, the Federal Reserve delivered Operation Twist as expected, but investors shouted a vote of no confidence.

No surprise that the markets focused on the Fed’s warning of  “significant downside risks to the economic outlook.”¹

This isn’t exactly breaking news, however. As we’ve noted previously, the drumbeat of negative economic data has increased in recent months, and market volatility has increased along with it.

We pointed out last week (Issue 35 • September 21, 2011) that, with interest rates already near zero, the Fed is out of realistic options to help boost the economy. Reading between the lines, we see the Fed’s message as: Markets and the economy are on their own.

This added even more turbulence last week to already volatile markets. In fact, since early August the S&P 500 Index has swung through a zig-zag trading range that’s more than 10 percent wide from top to bottom.²

Big Price Fluctuations a Familiar Pattern

This continues a familiar pattern of heightened volatility for financial markets which we outlined in a previous article (Issue 31 • August 24, 2011).

Roller-coaster market conditions like we’re experiencing now often follow periods of unusual economic and financial stress. The evidence seems clear to us that recent market gyrations have become much more common, fitting the historical post-crisis pattern.

Since 2000, daily stock price fluctuations of 4 percent or more have occurred nearly six times more often than they did on average in the 40-year period leading up to the year 2000.³

Going even further back in time, markets are noticeably more turbulent now than has been the case historically …

Since 1900 there have been 283 daily moves in the Dow Jones Industrial Average of 4 percent or more. That’s less than 1 percent of the time on average, but 11 percent of these 4 percent-plus price moves have taken place since October 2007.⁴

In other words, over more than a century of market data, more than one-tenth of the big daily price moves happened in just the past four years, and the trend has continued since last year’s flash crash …

Since the start of 2010, 30 percent of all trading days have resulted in stock market gains or losses of more than 1 percent. That’s a 50 percent increase in 1 percent daily moves above the average during the 1990s.⁵

In our view, this is a clear-cut trend toward greater stock market volatility.

The CNBC and HFT Effect

Investors and money managers with decades of experience will tell you that stocks are impacted more today by the 24-hour news cycle than ever before.

Practically everyone has access to free streaming online quotes and news these days. Add constant chatter of CNBC or Bloomberg TV and it’s easy to see the impact that media has had in today’s marketplace..

News that used to take several days or weeks to get priced into financial markets is now moving share prices in just a few hours.

The rise in hedge funds and high-frequency trading (HFT) may also play a role in rising volatility.

Firms specializing in HFT will buy or sell securities in huge volume, often looking to scalp only a fraction of a penny in profit on each trade, and then repeat the process hundreds or perhaps thousands of times a day. These rapid-fire trades now account for up to 60 percent of daily volume in stock markets.⁶

This kind of hyperactive trading activity can create big price swings, especially when markets are under stress already.

Still, just because some investors are making faster and more frequent investment decisions these days, doesn’t mean they are making well-informed decisions. Or, even that these trades are profitable.  

Try to Ignore the Daily Swings

Patient investors who have a longer-term perspective may come out better by choosing to ignore much of the daily and weekly price swings that create an emotional roller coaster of decision-making. After all, looking back over history, the trend in stock prices and earnings over several months or years, not day-to-day, is what matters.

In fact, the increase in price fluctuations can actually benefit disciplined investors who can use this opportunity to invest in high-quality, dividend-paying stocks when they appear attractively valued, as we believe many are right now.

More than half of the stocks in the S&P 500 Index pay investors more income in the form of dividends than the current yield on 10-year US Treasuries. Historically, that’s a rare event often indicating undervaluation for stocks. Plus, while dividends aren’t guaranteed, there are more companies raising dividends today than cutting them.

Another interesting way to perhaps take advantage of today’s volatility is by writing covered calls on the high-quality, dividend-paying stocks in your portfolio. Of course, options aren’t suitable for all clients, but, in some circumstances, a covered call approach may be worth considering.

Enhanced Equity Income Using Covered Calls

Writing covered call options on some of your existing stock positions can potentially generate extra income for your portfolio — over and above whatever dividend income you receive — while also helping to mitigate downside risk (limited to the amount of the premium received) from fluctuating markets.

Heightened volatility can present an added advantage when it comes to writing covered call options.

Option premiums tend to inflate during turbulent market conditions. Higher premiums make options more expensive for option purchasers, but remember, as a seller of options you are the beneficiary, potentially earning more income for the calls you write.

In this case, volatile markets can work to your advantage.

Many investors are looking for ways to make their investments work harder for them in these trying times. Specialized option strategies such as covered call writing may not be the right answer for every investor. It all depends on your own financial goals, experience, and above all, your tolerance for risk. Still, covered calls are considered one of the most conservative and widely-used option tactics.

If you are considering using options for your portfolio, there are several factors you need to carefully consider first, such as determining the right option contract month and suitable strike price. We don’t recommend venturing out on your own without first educating yourself about all the risks and rewards of options.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Federal Reserve Board, 9/21/11 http://www.federalreserve.gov/newsevents/press/monetary/20110921a.htm
² Bloomberg market data, 9/26/11
³ New York Times: Market Swings Are Becoming New Standard, 9/11/11
⁴ Washington Post: Smacked by big market swings, investors should alter their outlook, 8/20/11
⁵ New York Times: Market Swings Are Becoming New Standard, 9/11/11
⁶ Ibid.