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Thursday, May 13, 2010

Why Does My Stock Give Me Heartburn?

A fundamental question that nearly all investors have asked at one point or another or even still ask after many years in the market: Why does my stock bounce all over the place? All stocks are volatile to some extent because the overall market is volatile, but some are much moreso than others. Why does this happen?

There is no simple answer to this, but there is a basic framework that drives volatility in individual stocks and it can also be applied to the broader market as well in particular circumstances. The basic framework is along the following lines:

1. Volume levels (What % of shares outstanding trade in a given day?)
2. Earnings certainty (How stable are projected earnings?)
3. Previous volatility (Investor expectations are heavily based on the past. If a stock has been volatile in the past, investors assume it will be volatile in the future and this becomes a self-fulfilling prophecy)

Volume is a major factor for determining the stability of stocks. While low volumes do not necessitate that every day will be an adventure, they do make a stock more vulnerable to large moves. The basic logic is that if a stock only trades 50,000 shares a day, one huge buy order or one huge sell order can have huge sway over the course of the stock because generally there is not enough liquidity to absorb a large spike. However, if, say, a large buy or sell order hits Walmart (WMT), the high level of volume in Walmart shares will moderate that movement and prevent aberrant moves because the market's opinion of where the price of Walmart should be is much more developed than for, say, Consolidated Graphics (CGX). Broadly speaking, this dynamic means that larger companies will be less subject to volatility, but it is slightly more complicated than that. Some large stocks are more volatile than small companies for other reasons, two of which are listed below.

Earnings certainty is perhaps more vital. If the future earnings of a company are highly in question, it will be subject to much larger swings than a company that reliably delivers on its earnings numbers. This is simply because stocks are a direct function of the projected future earnings of the underlying company. If a company will deliver within $0.10 a share of its projected annual earnings for the next five years, it will trade in a narrow range because the market can generally agree on the value of the future stream of earnings. If a company will earn as much as $2 a share more or less than projected earnings in the next couple years, the market has much more room to disagree over the price. For an example, look at Wells Fargo (WFC) over the past three years compared to Becton Dickinson (BDX). In March 2009, no one could agree over what Wells would earn in the next five years and hence the stock dropped as low at $7 a share from over $40 just seven months earlier. BDX, meanwhile traded in a range between $80 a share and $60 a share because investors reckoned that the range of possible earnings for a medical supplies company like BDX would be fairly stable. Their pattern since then also reflects this difference.

Finally, prior volatility is an important contributor to future volatility. If investors have gotten used to a company or even an entire country being highly volatile, they will continue to treat it in such a way. The best example of this that I can think of is what happened to Brazil in 2006 when fears about rising U.S. interest rates sent Brazilian stocks down by nearly 40% in six weeks. Were there any real reasons to do this? Not really, but Brazil had absolutely collapsed as recently as 2002, had a major financial panic in 1998-99, and before that had another major panic in the early 1990s. As such, investors got used to the idea that Brazilian stocks would be highly sensitive to changes in U.S. interest rates influencing capital flows. The anticipation of volatility caused bogus volatility. As it was a bunch of nonsense, Brazil's markets bounced back rapidly, providing investors with very nice returns.

So what does all this mean? If you want to pick individual stocks and don't like volatility, keep these three factors in mind when selecting issues. However, keep in mind that low levels of volatility also mean that a stock has largely been priced efficiently and that there is little chance of high returns. Volatile stocks are priced inefficiently due to any combination of the factors outlined here as well as other factors and offer the possibility of much higher returns over time. Of course, you can also lose your shirt...or more.

This is by no means an exhaustive list of factors, but these are the most basic considerations to keep in mind.


  1. You forgot what I think are a huge source of volatility, hedge funds! I'll probably do a post in the future about that.

  2. Oh certainly. I was just covering the more conventional sources. However, these sources actually are what give the hedge funds much of their ammunition to manipulate stocks, particularly low volume issues.