Three Reasons Why Stocks Have Such Violent Swings

Thursday, Oct 30, 2008  |  Updated 12:09 PM PDT
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Bear markets are noted for their volatility—but more than 300 points in six minutes?

It's not as crazy as it sounds. Some analysts see several important factors contributing to the type of moves that the market witnessed at the close of trading on Wednesday, when the Dow Jones Industrials plummeted from a 250-point gain to a 72-point loss before most people had even realized what happened.

"It's actually not extraordinary," says Jordan Kimmel, a hedge fund and mutual fund manager at Magnet Investment Group in Randolph, N.J. "This is exactly how bear markets end, so it's not that uncommon at the very end of a bear market that has been this severe to see this kind of emotional trading."

The late-day market swing was attributed largely to an out-of-context statement from General Electric (NYSE: GE) chairman Jeff Immelt that some took as an earnings warning from the company, a Dow component and parent of CNBC.

But to market veterans, such a wicked swing in sentiment is merely the symptom of the type of volatility that plagues bear markets. That's because when volume is light—as it typically is in bear markets—the actions of a relatively small number of investors can have a profound impact on stock prices.

So what should investors do in this kind of market? Investment pros have identified three broad factors behind this kind of whipsaw trading—and how you can profit from it.

Speed of Information

Though there are common elements in this bear market with previous downturns, market analysts do see differences.

For one thing, no other bear market has ever had such swift dissemination of information through electronic media, nor the ease of trading that sometimes bedevils this one. That has compounded the volatility.

"It has been exacerbated compared with other bear markets," says Quincy Krosby, chief investment strategist at The Hartford. "With programmed trading everything is very quick, instantaneous. It's been exacerbated by technology, the movement of global information and rumors."

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That came into play sharply following the Immelt rumor.

"What that rumor did—whether it was true or false—the fact that this is a trader's market you're going to extrapolate from that rumor," Krosby says. "That's what happens. They act very quickly, and what happens is you've got to take all this information, all these various headlines, all these disparate headlines, disparate rumors, and you have to distill them in a second and extrapolate from them, and that's what I think happened yesterday."

That rapid pace of information only serves to feed the anxiety that has been prevalent through the market since the credit crisis hit.

"I don't think it's normal, but nothing that has happened over the last several months has really been normal," says Richard Sparks, senior analyst at Schaeffer's Investment Research in Cincinnati. "We're in a market that we've never experienced before. It seems to me to point to how much fear there is in this market."

Traders Play the Swings

The types of market movements that have led to the Dow swinging as much as 1,000 points in a single day essentially involve taking the old strategy of "buy the dips, sell the rallies" and putting it on steroids.

Asked whether bear market rallies can be even this violent, Krosby says, "not even, especially this violent."

"That has been the hallmark of these rallies—sell into strength," she says. "I have to say the volatility we're seeing, the swings are emblematic of a bear market."

As the trend gains steam and the market gets closer to finding a bottom, such swings tend to be larger in terms of points and percentages, and can happen later in the day, especially if the market is at an extremely high or extremely low level.

That's been evidenced throughout the month, as the chart below illustrates.

"You have to be very aggressive in going long at the bottom of ranges and selling when you get to the top of a range," Sparks says.

And the trend gets even more heated with the plethora of funds in the market that are being forced into selling their positions because of the need to raise cash in the volatile market.

Forced Liquidations

"Forced liquidation" is a term on the lips of many market pros, though it may not be something average investors consider very often. That's because the term only applies to the biggest risk-takers—the ones who now seem to be having, because of reduced volume, the most influence on moving the markets.

Traders using leverage to take positions in the market are getting hammered by the changing conditions and are being forced—through margin calls—to liquidate their positions to raise cash to meet their obligations. These orders usually don't come until near the end of the trading day, and they wreak havoc on a market looking for stable ground.

"I believe at this stage everybody who has wanted to sell has sold already and what is left right now—and we'll only hear about this in the future when the story comes out—is the forced liquidations taking place both in hedge funds and mutual funds," says Kimmel, who does not use leverage in the funds he manages.

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"You're seeing a lot of pressure from the liquidation side," he continues. "I don't think this is as fear-driven as it was, say, a few weeks ago. Now it's a question of some healing has already begun but you definitely have some guys leaving funds and that's not to be unexpected at the bottom."

How to Invest

The word "nimble" comes up often when asking investment advisors their strategy in such an environment.

Krosby calls it "the operative verb in this environment" while Sparks also uses the word freely and says being able to turn on a dime when it comes to investing poses unique challenges.

"It requires being nimble more so than in any other market environment that I can remember," he says. "You need to have very tight stops in place."

But the wild swings in the market—the CBOE Volatility Index (Chicago: VIX) has soared to previously unimaginable highs—provide opportunity as well.

"Long-term investors or institutional investors will take advantage of a down market to build their positions," Krosby says. "They don't build their positions in one fell swoop. You will take advantage of a selloff, especially if you realize it's more based on rumors or fund liquidating. It helps you in building your positions."

For Kimmel, this has all been the part of constructing a bottom that ultimately will lead to better times ahead.

"The value has been created, the public has been rattled. That's how you end up getting good valuations," he says. "This is how bear markets always end, with a distrust of Wall Street, with a distrust of corporate governance. I believe we were served up a fat, slow pitch and the doom-and-gloomers have been right for a short period of time. Then they'll go away again."

For more stories from CNBC, go to cnbc.com.

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