Volatile but vital
3 Nov 08
Colin McLean agrees that what has been happening in the stock markets is unprecedented but believes that investors should stick with equities
by Colin McLean
Falling share prices have been only part of investors’ concerns this year.
A more disturbing pattern in this year’s stockmarket behaviour has been volatility.
A daily move in the FTSE 100 of 8 per cent would once have been unthinkable – yet in 2008, this has happened several times. Investors want to know why, and whether it means the nature of their investments has changed. Even if shares are a good long-term investment, the recent rollercoaster raises the question whether investors should re-balance their overall portfolios to recognise greater risks in shares?
Some of the stockmarket volatility seems to have been actively encouraged by the authorities. In the US in particular, the aim appears to have been to maximise the impact of any intervention. This has typically involved bringing out news on Sundays, appearing to encourage rallies in Far Eastern markets which open first the next day. This can force hedge funds and other traders to close positions as soon as European and US markets open. In this way, action by the US Securities and Exchange Commission seems both to exploit volatility and to increase it.
If bad news emerges over weekends, though, it can set downward trends in place in a similar way.
Volatility ripples from one stockmarket to another. Authorities aiming to restore confidence via stockmarket rallies should recognise the need for consistency in official action and stability in markets. Unsustainable rallies are as harmful to confidence as falls. Attempting to put a spin on every government intervention – over-selling the likely benefits – may eventually generate disappointment.
And the careful analysis needed of the problem is not helped by politicians’ sweeping allegations about speculators, hedge funds and rumours. Nothing was proven by regulators about bank rumours and hedge fund trading in March, making it doubly difficult to tackle the fears now emerging. Indeed, the belated recognition of problems at some UK banks suggests that sellers of those shares spotted the problems long before the authorities.
The sharpest share price falls in banks came after short selling was restricted, and it is clear that October’s sharp price moves in banks reflected genuine fundamental concerns and changes in credit rating. The gap between the underlying reality and reporting of it to shareholders created a climate in which fear could flourish.
Volatility is often dismissed as reflecting investors’ lack of conviction in underlying values, but the real value of shares in some companies can swing widely, if they have little room for error in their balance sheets. This is clearly the case with some banks whose balance sheets dwarf their market capitalisation. The true value of those banks is the difference between some extremely large numbers, with even a small proportion of losses on lending threatening a huge portion of total equity.
In other sectors too, values can change quickly. Many businesses have high borrowings and are much more vulnerable. So a period of weaker trading can mean breaching the terms of bank borrowing.
The best way for companies to stabilise share prices and address stockmarket fears is to provide the facts. Fear feeds on a news vacuum. The right response to falling share prices is not an attack on investment managers and hedge funds, but candour from company boards. Information does not just have to be accurate, but should also genuinely represent the whole truth and be delivered in a timely fashion.
The merits of equity investment have not changed, but investors need a time horizon that spans at least one stockmarket cycle. Surprisingly, although volatility is currently high, the trend in recent years has been decline, despite the increasing synchronisation of the global economy.
In the coming months, volatility should fall. However, companies and regulators have a part to play in achieving this.
For most investors, shares will be one small part of their total investments, and it is important to see price volatility in context. An overall portfolio should be constructed to tolerate short-term noise. Investors should not be unsettled by temporary share price moves.