Volatility Is Back

The real mystery about the 416-point plunge in the Dow Jones industrial average last Tuesday isn’t that it happened, but that it didn’t happen a long time ago. Unfortunately, last week's fall didn't last just one day. For the week, the Standard & Poor’s 500-stock index fell 4.4% while the Nasdaq Composite lost 5.9%.

Before last Tuesday’s 3.5% fall, the S&P 500 had gone 949 trading days -- close to four years -— without as much as a 2% decline. It was the longest period without such a decline since 1950.

"What we've had is a return to normal," says Chuck Zender of the Leuthold Group, a Minneapolis-based research firm. "Declines like this used to be fairly common."

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Take 2002, admittedly an abysmal year for stocks. In 7% of that year's trading days, the S&P either fell or rose by 3% or more. And the tech-laden Nasdaq fell or rose by 3% or more in 16% of trading days, Leuthold reports.

Nevertheless, investors were understandably shaken up by the Feb. 27 selloff -- because it hadn't happened in so long. What does the big drop mean after such a long, unusually placid period? It doesn't mean that the bull market is over. It does mean, however, that volatility will almost certainly increase. And it could mean an end to a lengthy period during which it paid to invest in riskier stocks and bonds.

Sam Stovall, chief investment strategist at S&P, examined all eight periods since 1959 during which the market had gone more than a year without a 2% drop. On average, these tranquil periods lasted a whopping 652 trading days -- or more than two and a half years. Once those strings were snapped, however, the market, on average, suffered five one-day swoons of 2% or more in the subsequent 12 months.

What's more, once the calm was shattered, the market bounced around more from day to day in all of the subsequent 12-month periods, Stovall found. On average, the market's volatility soared by one-third.

His conclusion: The past is prologue. "It appears very likely that we will experience an upsurge in volatility from the S&P 500 in the coming year."

But more volatility doesn't mean the market will go down. Steve Leuthold, who heads the Leuthold Group, is probably as good at predicting the market's future direction as anyone. He's bullish. Indeed, he thinks the selloff likely injected some much-needed fear into the minds of traders. Yes, fear is a good thing: As the old saying goes, every bull market climbs a wall of worry. When the worry stops, the bull market often does, too.

The selloff should, however, give you a good reason to take a hard look at your portfolio. If the market becomes more volatile, I think it's likely that some of the riskier assets, which have done very well in recent years, could lose some of their luster. Take some profits here.

What falls into this category? High-yielding "junk" bonds and stocks and bonds from emerging markets are prime candidates to trim. Yes, the long term looks wonderful for developing nations, such as China and India. But shorter term, it might be wise to reduce your exposure. I wouldn't put much more than about 5% of my stock money in emerging markets today.

Stocks of small companies look vulnerable, too. I'd cut these back to no more than 15% of your stock money. Perhaps we'll look back on Feb. 27 as the time when large-company stocks, particularly growth stocks, finally took the lead in the market after slumbering since early 2000.

Big-company funds to consider buying: Selected American Shares (SLADX), T. Rowe Price Growth Stock (PRGFX) and Vanguard Primecap Core (VPCCX).

Steven T. Goldberg is an investment adviser and freelance writer.