Stock Market Volatility: Here's What's Happening

After two consecutive winning days brought U.S. stocks back to within 1% of their all-time high, the major indexes suffered bruising losses on Thursday, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average losing 2.1% and 1.6%, respectively. As has been the case in recent weeks, the sell-off was particularly acute in technology shares and high-flying momentum names, pushing the tech-heavy Nasdaq Composite   down 3.1%, its worst daily performance since November 2011. Drilling down still further, biotechnology shares, which were manifestly overvalued this year, took a severe hit: The iShares Nasdaq Biotechnology ETF fell 5.6%; the index it tracks, the Nasdaq Biotechnology Index, now sits on the cusp of bear market territory after closing 19.3% below its 52-week high.

The breadth of losses on Thursday was substantial, with 94% of the stocks in the Russell 3000 Index finishing in the red, including three of the most high-flying large-capitalization names: Facebook, Netflix, and Tesla Motors, were all down at least 5%.

Meanwhile, Thursday's price action caused investors to ramp up their expectations for stock market volatility in the near term, with the CBOE Volatility Index rising 15% to 15.89. The VIX Index, nicknamed Wall Street's "fear index," is calculated from options on S&P 500 futures and reflects market expectations for volatility in the S&P 500 over the next 30 days. Investors have become accustomed to unusually low volatility over the past couple of years -- Thursday's closing value remained more than 20% below the index average going back to its inception in January 1990, despite indications that the market (or large chunks of it, at any rate) is undergoing some sort of correction.

In case you're wondering, here's what's going on (or a reasonable hypothesis): Stocks rallied hard last year and they kicked off 2014 somewhat overvalued. Investors are coming to terms with that reality now and rerating valuations downward. Those sectors that experienced the greatest gains (and exhibited the highest degree of overvaluation), biotechnology and social networking, are the same ones that are now in the eye of the storm.

For well-diversified, long-term investors, this process need not be a source of concern, let alone anguish. Recent Nobel laureate Robert Shiller of Yale University showed that the stock market is more volatile than is warranted by the fundamentals. The shifts between overvaluation and undervaluation are a major source of stock market volatility, and that's what appears to be taking place right now (although I cannot say how exactly this will unfold -- we may not actually reach undervaluation anytime soon, for example).

Let me reemphasize the point that falling stock prices need not be of any concern to long-term investors; if anything, they ought to be welcome. For an eloquent explanation of that point, I'll refer you to this passage from Warren Buffett's 1997 letter to Berkshire Hathaway  shareholders:

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

Do you expect to be a net saver during the next five years? If so, your results will surely improve if you tune out the chatter -- especially as it becomes increasingly shrill -- about the market's daily variations.

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Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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