Making Sense of the Stock Market's Wild Ride

Fortunes are won and lost from day to day in a volatile market that shows no signs of settling down soon

By Ben Steverman

Once again, the wild stock market has made fools of those who would try to predict its direction.

Amid buckets of bad news and a gloomy mood on Wall Street, stocks took a violent swing to the upside. In just three days, the broad Standard & Poor's 500-stock index advanced 10.7%, which is more than what stocks rose in four of the last five years.

That followed a scary descent for the S&P 500 to the lowest levels in more than 12 years. From Jan. 6 to a low on Mar. 6, the S&P 500 dropped 29%.

All this volatility makes stock market investors look like they can't make up their minds. If stocks prices change so much from Monday to Thursday, investors apparently don't know what U.S. companies are really worth.There are two common ways of explaining the market's recent rally, and both underscore investors' extreme uncertainty and skittishness.
Citigroup Memo

The first explanation is based on theories about how markets work. For one thing, stocks rarely fall day after day without a break. Stocks "were more oversold than [they've] been in my 13 years on Wall Street," says Dave Rovelli, managing director of equity trading at Canaccord Adams. "We were due for a rally."

Stocks seemed to react to a Mar. 9 letter from Citigroup (C) Chief Executive Vikram Pandit, touting his troubled bank's performance in the first couple months of 2009. But to Rovelli, that was just a trigger to a rally that would have started eventually anyway. The S&P 500 had declined in 13 of 16 trading sessions from Feb. 13 to Mar. 9.

Richard Sparks of Schaeffer's Investment Research agrees. "The market was ripe for a rally," he says.
Shift in Market Psychology?

The rebound was driven not by long-term investors but by traders with a very short attention spans. "It's driven by big money, momentum players," Sparks says. "It's such a tough market to trade," that these market participants focus on "very short-term time periods." Traders jump on market trends, but those moves don't last long and can turn on a dime.

The volatility is most striking in the financial sector. From Mar. 10 to 12, one measure of the financial sector, Financial Select Sector SPDR (XLF) rocketed 30% higher. The same index had lost half its value from the beginning of the year to Mar. 9. Professional traders are no doubt making—and also losing—a lot of money on these rapid moves. Successful traders must be "nimble enough and right enough," Sparks says.

Some wonder, though, if the past week marked a significant shift in market psychology. Dan Genter, president of RNC Capital Management, says the recent rally doesn't just reflect the moves by short-term traders but also by long-term investors who are beginning to put money into the market.
Pricing In Worst-Case Scenarios

Stocks—particularly bank stocks—were trading at absurd prices. "All these companies are not going out of business," he says. By falling to 1996 levels, stocks priced in a worst-case scenario for both the economy and for earnings prospects. At those levels, "unless you think the world is coming to an end, it's difficult not to be bullish long-term," says Uri Landesman of ING Investment Management (ING).

Few in the market believe the world has solved its economic and financial problems—quite the opposite. But, Genter says, "it's not just in freefall anymore." He hopes that, by dropping to an extreme low this month, stocks now have a new low below which they're unlikely to fall again.

Landesman says the market needs to see a strong rally from these levels. Or, he worries, stocks will lose their momentum and fall back again. Rovelli also warns of more volatility ahead, particularly in the next couple weeks as bullish and bearish traders battle over the direction of the market.
Long-Term Volatility?

The wild ride could last much longer than that. Scott Jacobson, an expert on volatility and chief investment strategist at Capstone Sales Advisors, says high volatility in the stock market tends to last for two to four years during and after a recession. "I'm sure we have two years of volatility at least," he says.

The problem with a volatile stock market is that it doesn't just reflect investor uncertainty. Wild swings also cause uncertainty and confusion among the investing public, who see their retirement nest eggs grow or shrink erratically from day to day.

Market observers often say the stock market is supposed to move higher six months before the economy does. But, from this standpoint, it's impossible to know whether the market's newfound optimism is a harbinger of things to come, or simply a temporary rest stop on the market's trip ever lower.

Steverman is a reporter for BusinessWeek's Investing channel.