Dow Correction: Why You Shouldn't Panic Over Market Volatility


On Wednesday, the Dow Jones Industrials lost almost 100 points, finishing near the day's lows as investors worried about a variety of factors that could hurt the market's future prospects. That range of issues runs from the threat of war in Ukraine to overextended valuations on high-flying momentum stocks and recent IPOs. Yet, one key fact should keep you from panicking about the Dow's performance in the months to come: Everyone's talking about a pullback as though it were an imminent event, yet for the most part, investors aren't putting their money where their mouths are. After all, the S&P Volatility Index remains at relatively low levels, showing a lack of bearish options bets on the Dow.

Irrationality vs. solvency
Today's drop did spur some increase in the Fear Index, with an 8% gain helping push shares of the iPath S&P 500 VIX ST Future ETN up almost 2%, and the leveraged VelocityShares Daily 2x VIX ST ETN up 2.5%. But with the index still around the 15 level, volatility-tracking investors aren't allowing themselves to get faked out by what have proven to be false alarms on Ukraine in recent weeks.

Source: Wikimedia Commons, Jean-Pierre Lavoie.

But more importantly, the growing chorus of experts arguing that the stock market needs a correction in order to be fairly valued is itself a sign that such a correction likely won't come immediately. Certainly, stocks in high-flying sectors like biotechnology or renewable energy have plenty of room to make what appear to be large corrections without making much of a dent in the huge share-price gains they've enjoyed during the past year or two. But when it comes to the broader market, weakness in one area seems to be joined by strength in others, as investors seek out better opportunities within the stock market rather than giving up on stocks entirely.

When you consider the alternatives to stocks in this economic environment, that reluctance to sell out of the market makes a lot more sense. Even after the recent rise in bond yields, 10-year Treasuries paying around 2.7% are even enough to cover the combined impact of inflation and taxes for many investors. Moreover, if rates rise in the future, those who don't intend to hold onto intermediate-term bonds until maturity face the threat of capital losses, as many people discovered the hard way last year. Similarly, gold has posted a decent rise in 2014, but it also appears vulnerable to the same trends that have hit the stock market, and it's uncertain whether gold could rise if stocks encounter a large correction.

Sometimes, the investing crowd turns out to be right, and the loud chorus of those calling for a big market correction could indeed get their wish in short order. But the more likely scenario is that whatever hits the market will come out of left field -- and at a time when investors aren't nearly as well-prepared for it as they are now.

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