A Volatile August in the US Equity Markets

August has been a notable month in the US equity markets. Since I won't be writing posts next week, I thought I'd express some thoughts about it today.

If the S&P500 Index closes next Wednesday anywhere near it's current (mid-day Friday) level of 1168, it will be the worst monthly decline for the average since February of 2009.

My proprietary volatility measure for options soared from a 'call' allocation to a notional, but not very strong 'put' by the second day of August. Just two days later, the measure was in full put territory. And has more than doubled since then. My volatility measure hasn't been this high since late March of 2009.

The options-related indicator, however, is much more sensitive than my equity signal. More 'real-time,' if you will, because options move so much more quickly.

That said, such high volatility rarely persists for months. It did persist in the fall of 2009 through early 2010, thanks to the compound nature of an economic recession and a financial sector crisis. I doubt anything quite like that is looming just now. So to benefit from the decline either through puts or shorting equities, one may have already missed the fattest part of the phenomenon.

The equity signal has yet to move to either an 'out,' i.e., uninvested or cash, allocation, or 'short' position. But it's easily only a few months from signaling short, depending upon how badly the S&P continues to perform. Suffice to say, even a merely lackluster index performance for the next few months could signal short allocations by year's end.

With this background, it's been entertaining to listen to the many guest pundits and hosts on Bloomberg and CNBC this month argue back and forth that it's either the best of times, or the worst of times.

Really, it all depends upon your asset levels, risk appetite, and time horizon.

While I continue to believe that macro-trends argue for lower global economic growth rates among developed nations for the foreseeable future, as consumers save more, to replace the expected shortfall of non-existent government-promised pension and health care benefits, that doesn't mean I see equities collapsing.

Rather, I believe equity strategies like my own, which has continued to handsomely outperform the S&P this summer, even amidst the continued market decline, will identify and hold shares of companies which generate positive total returns, both absolutely and relative to the index.

If one can maintain a long investment horizon and sustain some near-term softness in returns, I suspect that, mostly long positions will continue to pay off. My own equity strategy may yet signal a period of being in cash or short. However, barring it being of a duration like that of the post-tech-bubble collapse, or 2008, such a period of short positions are unlikely to be significant. It's too early to tell.

What is clear is that August's sudden spike in volatility in US equity markets is a warning to be prepared for an investing inflection point. The speed with which, and the levels to which volatility has risen are rare. If the equity market is provided sufficient fuel to prolong and increase such volatility, look out. Otherwise, chances are good that it will begin to ease, accompanying a long, slow rise in the S&P500.