Being involved in financial markets for more than two decades, I have observed that amateur investors tend to hyper-focus on stock selection while discounting other pieces of the investment puzzle. Though stock screening, analysis, and timing are integral exercises that are necessary for profitable investing, new investors tend to discount analysis elements in other areas, including:
1. Asset allocation, sound portfolio management and execution: The importance of sound allocation (position sizing), portfolio management (a risk management framework), and execution (how and when you enter a stock) cannot be understated. Investors should spend time (particularly outside of market hours) studying themselves. Trust me, the added effort pays dividends.
2. Market direction: Few new investors realize that approximately 75% of a stock’s move is based on the general market (and industry’s) movement. To simplify, if the S&P 500 Index ETF (SPY), the Dow Jones Industrial ETF (DIA), or the Nasdaq 100 ETF (QQQ) are in a bull market, most portfolios will gain ground, and vice versa.
3. Psychology and known volatility events: Many (but not all) volatility-induced market events are known ahead of time. Economic events can lead to volatility and volatility can spur emotionally-driven, poor, kneejerk decisions – especially for inexperienced investors.
In today’s commentary, we will examine #3 in depth and illustrate how it can impact #1 and #2 for market participants.
What Drives Market Volatility?
Market volatility refers to price range expansion or wide market fluctuations. As I mentioned, investors cannot predict all volatility events. For example, no investor could have predicted the terrorist attacks that shook markets in September 2001. Nevertheless, other volatility-inducing events are known ahead of time. By preparing for these events, investors can face markets from a position of strength and gain a significant edge. Below are examples:
1. The Federal Open Market Committee (FOMC) Meeting
The U.S. Central Bank or FOMC meeting occurs eight times a year (unless an emergency meeting is scheduled) and on average about every six weeks. The central bank makes monetary policy decisions and discusses future decisions and macroeconomic trends. Legendary investor Stanley Druckenmiller summed the importance of the FOMC up best when he said, “Earnings don’t move the overall market; it’s the Federal Reserve Board. Focus on the central banks and the movement of liquidity. Most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets. My experience teaches me that there are typically two or three false market moves on FOMC days.
2. Personal Consumption Expenditures (PCE)
PCE is released monthly by the Bureau of Economic Analysis (BEA) and records the average price changes for domestic consumption. PCE is critical and market-moving because it is the Fed’s “preferred inflation gauge.” For example, if inflation is hot, the Fed may hike interest rates (normally a bearish headwind for equities). Conversely, the Fed may cut rates to spur growth when GDP growth slows.
3. Jobless Claims & GDP
Jobless claims and GDP are important metrics to watch because investors look to these metrics to determine the economy’s health.
4. End of Month, Quarter or Year
Institutional investors are the primary drivers of stock because of their vast monetary assets under management (AUM). These “elephants” often use the end of specific time frames to rebalance their portfolios, which leads to short-term market turbulence. When a calendar year ends, these deep-pocketed investors “window dress” their portfolios (sell weak stocks to buy strong stocks to make their portfolios look stronger to clients).
5. Options Expiration (OPEX)
Option expiration occurs on the third Friday of each month, often leading to increased volatility in underlying equities as investors roll, close, or exercise positions. The impact of OPEX on volatility has been exacerbated in the past few years with the growing popularity of risky 0DTE (zero days to expiration) options.
6. Elections
The run-up and aftermath of elections induce investor uncertainty, which causes volatility. The past few U.S. elections have caused volatility in the major U.S. indices. More recently, the iShares MSCI Mexico ETF (EWW) plunged more than 10%, and the iShares MSCI India ETF (INDA) plummeted 6% after investors did not like the election outcomes in those nations.
7. Tax Deadline
The tax deadline in America occurs annually in mid-April. After a strong year, investors with large profits are forced to sell positions to pay large tax bills.
8. Earnings Season
Earnings season, when most prominent Wall Street firms release financial results, occurs a few weeks after the end of each fiscal quarter. Because fundamentals ultimately drive performance, earnings are an important market event to watch. Investors should also mark on their calendars when the positions in their portfolio report so that they can prepare and manage risk ahead of time.
Bottom Line
Volatility-inducing events, such as FOMC meetings, earnings, and inflation numbers, can lead to market volatility. Savvy investors understand and prepare for market-moving economic events.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
