Turning Explosive Volatility into Opportunity

Uncertainty. It’s an ugly word in any context, isn’t it? Unfortunately, that’s especially true in finance and capital markets. Nothing spooks investors and traders out of stocks more than other investors and traders getting spooked out of the same stocks; in other words, when uncertainty does hit the market, it breeds more uncertainty, and before you know it, everyone panics because regardless of the individual performance of individual companies, everything seems doomed. Money is pulled from investments as profits are taken and positions get cut out of portfolios, and the market is flooded with liquidity. Flights to safety are made in gold (historically speaking, it’s a precious metal and therefore a safe haven) and government debt. Massive selloffs begin to take place and global indices move down 2%, 4%, or even more in less than a week. What I’m talking about is a market correction due to volatility.

In our earlier posts, we’ve touched on the prevailing concepts of volatility in the greater financial markets and indices like the DOW and the S&P 500, which is now more than ever an important theme and trend for us to understand. But here at World Market Media, we focus on our niche; our expertise is in undervalued and underreported small cap companies from around the world.

Our World Market Media indices performance for 2010 benchmarked against the major indices reveals the following:

• WMM MircoCap Index – down 33% from a high of 1,271 reached on March 11th, 2010.
• WMM NanoCap Index – down 19% from a high of 1,130 reached on April 29th, 2010.
• DOW – down 9.6% from a high of 11,205 reached on April 26th, up only 2% from the 2010 low of 9,908 breached on February 8th.
• S&P 500 – down 11% from a high of 1,217 on April 23rd, up only 2% from the 2010 low of 1,056 breached on February 8th.
• NASDAQ – down 12% from a high of 2,530 reached on April 23rd, up only 4% from the 2010 low of 2,125 breached on February 4th.

This demonstration illustrates a striking divergence in comparisons between our indices and other major stock markets, and the primary deviations are in the players, the capital structure, and the availability of shares. In other words, the investors who are buying shares of the small capitalization companies that make up the WMM Micro and NanoCap indices are not the same investors who are buying shares of companies that make up the DOW, the NYSE, S&P, or the NASDAQ. The difference in liquidity is staggering when compared, where on any given day 6-10 trillion shares exchange hands on the large cap indices. Shares of the companies in our Micro and NanoCap companies, for example, may only trade a few hundred shares in a day, so therefore small cap stocks may not be as easy to get in or out in a downturn because there simply aren’t any buyers or competing prices in the marketplace. Further, these companies are small cap for two very obvious reasons – they are usually start-up companies with little or no revenues who have fewer shares outstanding than the bigger cap companies – tightening supply, demand, and prices for the stock.

Of course, volatility affects Micro and NanoCap companies in a much more dramatic fashion than the mid and large cap companies, and volatility has been rampant this week (really, in most of 2010). Consider this: if the mid and large cap companies like Proctor and Gamble, Microsoft, Citigroup who are highly-valued, profitable, and stable are demonstrating spectacular swings in their stock prices, what chance would the share price of a small-cap start-up company have to avoid those same major swings? The investors who are in invested in those major companies on those major exchanges are typically institutional investors or hedge funds who have more resources available at their disposal to hedge their positions during these periods of ugly volatility by taking positions in options and other derivatives that will (at least in the short run) limit their risk. For example, they may be long in Company A, but during periods of uncertainty, take out a short position against Company A to limit their downside losses. We don’t see those same strategies being employed by players in the Micro and NanoCap markets. The massive drops we’ve watched in stock markets over the past few weeks, including the “Flash Crash” 1,000 point plunge in the DOW in early May, are directly attributable (at least in major part) to those very same institutional investors and hedge funds winding down the hedge options I’m talking about. These functionalities don’t exist in the stocks of the companies we cover.

So while the WMM MicroCap index may be down 33% since 2010 highs, we must remind ourselves that it’s all relative. The good news going forward is that historically, small-cap and micro companies with brilliant, innovative ideas who eventually bring their products to market can be capitalized on by any smart, savvy investor who is able to discover and identify them today in anticipation of their promotion and introduction into the small, mid, and eventually large cap indices tomorrow. Even more important are the implications going forward for those widely-held large cap indices – which have mostly all by now broken key technical support levels – and what that could spell for the Micro and NanoCap companies. Are we in a downward correction, explicitly defined as a change of 10% followed by a recovery and recommence? Or is this the beginning of a long, painful trend in which the DOW could fall another 25%? Where only time can give the answers, volatility can give us indications, and according to our research, it’s still looking pretty uncertain.