High Anxiety: Controlling Fears of Volatility and Stagflation By Ernie Ankrim, Ph.D., Chief Investment Strategist Russell Investments February 29, 2008 Thirty years ago, Mel Brooks directed (and co-wrote and starred in) a spoof on Alfred Hitchcock movies titled High Anxiety. Brooks played a psychoanalyst at an institute for the "very, very nervous." The film was very, very funny. But there's nothing funny about people in real life who are very, very nervous about their investments. And that's what's happening today. Investment professionals are anxiously searching for the answers to two questions we're now hearing a lot about: Is today's market volatility unprecedented? Is stagflation—a combination of high unemployment and high inflation—approaching? Or even here? Let me begin by saying, "Relax." Everything isn't rosy by any means. On the other hand, we have astonishingly short memories when it comes to the scary elements of the market. We tend to focus only on the current market environment. This can mislead us into thinking that the situation we now face is both unique and threatening. That can induce financial advisors, institutional investors and individuals to take dramatic action, which often turns out to be well intended but short sighted and potentially negative. Here's what you should consider... A broad view of the VIX Many commentators see our current market as astonishingly volatile. From up close, that's understandable. Let's say you examine a single day—January 22, 2008. That day saw a huge intraday move of 600 points on the Dow-Jones Industrial Average. By mid-day, the Dow was down 300 points. At the close, it was up 300. But was this really astonishing? Obviously, we wouldn't conclude from January 22 that every market day is characterized by 600-point spreads. It's just a single day. In the same way, looking at one day in which the market had virtually no movement, wouldn't lead us to believe that volatility doesn't exist. The key is adding perspective by examining data that is statistically valid because it reflects market activity over time. To do so, let's look at the CBOE Volatility Index® (VIX®). The VIX measures the near term volatility implied by the price of S&P 500 options on the Chicago Board Options Exchange (CBOE). What we discover is that long term, volatility is fairly low. Short term, measured in days or weeks—even months—volatility seems high. Moreover, the VIX number on any single day is meaningless unless you compare it to that of another day—preferably years apart. What might we see? Right now, the VIX is about 25. Two years ago it was 13. We now have a little perspective: the market is nearly twice as volatile today as two years ago. I'm not unsympathetic to people who express concern. But there's more to the story. Volatility rises and falls over time. We're above average today, but not by "unprecedented" amounts. The black line indicates the average over the time period shown. The blue line indicates the VIX level over a rolling 8 month period. The use of rolling periods allows the user to see longer term trends rather than focusing on the short-term volatility of those periods and provides a more accurate picture of trends. The orange line indicates the actual VIX level. Let's go back to 1990. From this vantage point—one that long-term investors are more apt to appreciate—volatility is only slightly above average as defined by the VIX. So how should we feel? Human nature being what it is, investors get upset with volatility when the market goes down but not when it goes up. And even a down market isn't all that meaningful unless your portfolio objectives are short-term, such as tuition payments (in which case, you should have had minimal exposure to stocks to begin with). Stock market volatility goes with the territory of the higher returns stocks have offered long-term over less volatile assets like bonds and money market funds. The stock market delivers negative days, weeks, months, and even years. Yet historically, it has risen. The fact is we've experienced periods of much greater volatility during the last ten years than we're seeing now. While high volatility can add insult to the injury of down markets, it is easy to forget that it can also occur in particularly rewarding ones. The following numbers tell the story.         VIX Index     Russell 3000® return, including dividends   Average daily VIX level   Maximum daily VIX index 1997   +31.70%   22.4   38.2 1998   +23.95%   25.6   45.7 1999   +20.89%   24.4   33.0 2000   -7.48%   23.3   33.5 2001   -10.45%   25.7   43.7 2002   -21.54%   27.3   45.1 8/07-2/08   -6.51   23.5   31.1 Volatility doesn't tell us which way the market is going. It simply measures the variation of movements in one direction or another. From the above, we can conclude that volatility in itself does not pose danger. Yes, the 2002 VIX set a record high for the annual daily average, while the market tumbled. But the 1997, 1998 and 1999 VIX numbers were nearly as high, and investors loved their returns. Getting a grip on stagflation The economy is slowing. We know that. (See Déjà Vu All Over Again?) Rising unemployment hurts. So does inflation. The Consumer Price Index posted gains of 0.4 percent in both December and January, higher than economists expected. Core inflation, which excludes food and energy, rose 0.3 percent, its biggest jump in seven months. That brought the annual CPI rate to 4.3 percent. No doubt, we'll hear comments from the Federal Reserve Board, which wants to save us from a serious recession while holding down inflation—no small task. But do we have "stagflation" on our hands? Again, stepping back from looking at today's data alone, we can be encouraged. Let's examine the "misery index" created by the economist Arthur Okun. It combines unemployment and inflation rates. We saw maximum pain way back in May 1980 when the index read 21.9. The inflation rate that year was 14.4 percent and the unemployment rate 7.5 percent. Yes, that was painful! During the last decade, the misery index has actually been higher in some good market years and lower in bad ones. The red line indicates the average over the time period shown. Looking at the past decade, the misery index stands at 9.2 (obviously well below that of 1980) but below the decade high of 9.8 in September 2005. Interestingly, no one in September 2005 complained about the misery index. Why? In spite of the numbers, the economy and the market were doing quite well. So the "stagflation" index itself wasn't tightly correlated to investors' feelings of wellbeing. Today's misery index remains in a fairly low average range compared with that of the difficult 1970s and 80s. Now let's step back even further and examine the misery-index figures for the last 50 years. This period covers some of the best of times—the 1950s and 1990s—and some of the worst. From the late 60s to the early 90s—particularly in the 70s—the U.S. economy suffered great pain. So while the misery index trend is up today as compared to the last two years, it just doesn't compare with the index in the 80s when the term "stagflation" was coined. We're not even close. That historical perspective should calm us a bit. So where are we? Yes, the economy is slowing. Yes, inflation is kicking up. But our "pain index" is below average for the last fifty years. In reality we may be far better off than we might think. So while high anxiety is understandable, it isn't warranted. Investors should not misread a short-term situation and be fooled into thinking that things are worse than they are. This being said, will the economy be robust by year's end? I don't think so. And the Fed will have to keep paying attention to inflation, as well. What's critical is that investors don't panic and let less-than-average "misery" experiences lead them into greater-than-average responses. Of course, the media will continue to draw attention with talk of unusual volatility and stagflation. But taking the long view, this isn't reality. Concentrating too much on too little data is comparable to looking at the ocean from a rowboat. Normal swells seem to threaten destruction. Those same swells seen from a cruise ship barely raise an eyebrow. It's worth remembering: investors should rededicate themselves to keeping a long-term horizon in mind and review their portfolio to assure a diversified, balanced approach. I mentioned in my 2008 Outlook that investors would be well served to get their portfolios in order then pull a Rip Van Winkle and sleep through this year—sure protection against high anxiety and panic moves. I haven't changed my mind. These views are subject to change at any time based upon market or other conditions and are current As of February 25, 2008. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. This is not an offer, solicitation, or recommendation to purchase any security or the services of any organization. Russell 3000® Index measures the performance of the 3,000 largest U.S. securities based on total market capitalization. Dow Jones Industrial Average: Price-weighted average of 30 actively traded blue chip stocks. Consumer Price Index: A measure of inflation in the economy, widely used as a cost-of living benchmark. The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Copyright© Russell Investments 2008. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Securities products and services offered through Russell Financial Services, Inc. (formerly Russell Fund Distributors, Inc.), member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. RFD 08-7480. First used: February 2008.			Comment on this PERSPECTIVE What is your impression of Ernie Ankrim's insights? Are there topics you would like to addressed in the future? Provide your feedback.   WHY Russell? See the difference Russell's investment approach can make   Printer friendly version of this page Send feedback or comments Site Search

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