Plenty of ordinary investors are bailing on the U.S. stock rally. Although the S&P 500-stock index has returned a generous 13% this year, atop a 27% return last year, mutual fund owners have taken more than $100 billion out of domestic stock funds since the start of 2009, including twice as much this year as last, according to the Investment Company Institute.
Why are they leaving? Valuations aren't likely to blame. The 500 index is still 21% below its 2007 peak, and profits for its member companies are projected to set a new record next year. Demographics play a role in the stock-fund exodus – economists say aging Americans are showing a preference for bonds – but much of it seems owed to skittishness. The largest months of outflows in recent years came during autumn 2008, when Lehman Brothers went bust and the market plunged, and in May 2010, when a one-day "flash crash" left prices intact but rocked confidence.
Perhaps Joe and Sally Stockholder are missing the fundamentals that have impressed market pros. Or perhaps their intuition is telling them that the risks of stock investing have fundamentally shifted for the worse.
Sophisticated risk measures show few warnings signs. The Chicago Board Options Exchange Market Volatility Index, or VIX, spiked in late 2008 and again following the flash crash, but has since returned to normal levels. The measure is said to reflect fear. In reality, it is based on what options prices say about expected market volatility over the next 30 days. For most investors, sharp market movements that actually occur matter far more than ones that are merely predicted by Wall Street geeks. And more are actually occurring.
The Fickle VIX
Since 1950, the S&P 500 has changed by an average of 0.7% per day, counting both gains and dips. That in itself seems a high figure, seeing as yearly returns since 1950 have averaged 7% after inflation, but consider the number of days with movements of more than 3%. There have been 199 of them since 1950. The past 25 years have brought 157 of them and the past 15 years, 135 of them. In other words, since 1950, two-thirds of extreme price changes have been crammed into the most recent one-quarter of days.
A Wilder Ride
Intraday price moments can affect investor mood as much as closing price changes, as the flash crash showed. That the Dow dropped 9% by midday says more about risk than its closing down 3%. Since 1962, there have been 73 days during which the S&P 500's high price and low price differed by more than 5% of its closing price. Remarkably, 40 of them have fallen in the past three years.
More Big Swings
Source for all 3 charts: Commodity Systems
When risk increases, investors should demand higher returns (and hence, lower prices) to compensate. The economist Harry Markowitz demonstrated that with Nobel-winning math 60 years ago. Savvy investors have known it without quantifying it since before the birth of stocks four centuries ago. The recent rise in extreme price movements suggests that something is amiss, be it algorithmic trading, central bank meddling, boom-and-bust profit cycles or some other goblin.
Joe and Sally Shareholder are right to reduce their stock holdings while waiting for an explanation.
Jack Hough is an associate editor at SmartMoney.com and author of "Your Next Great Stock."
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