In a newly released song, country singer Brad Paisley reveals his true nature. Titled “I’m Still a Guy,” the song’s lyrics note that while he might occasionally walk his wife’s sissy dog or hold her purse at the mall, eventually he will revert to behavior more typical of a male.

In the past few weeks, we’ve seen the major stock indices revert to more typical market behavior.

In mid-July 2006, major market indices began a powerful advance. One of the unique features of this rally is that with the exception of a small pullback in February 2007, it has been a smooth, sustained rise. Much of the volatility that normally accompanies market movement was absent. Intraday trading ranges were tight as the markets marched steadily upward.

Fast forward to mid-July 2007, Not only does the market endure a correction, but daily volatility increases dramatically.

It is uncomfortable for many investors when major indices have daily swings of 1%, 2% or even more. This most recent episode has seemed particularly difficult because we haven’t seen this kind of volatility for more than a year.

The chart below makes it easy to see how market behavior has changed.

The black vertical lines show the daily price activity of the Nasdaq over the past six months. On the left side of each line is a tick that marks where the index opened on that day. The line itself shows the trading range during the session. A tick on the right side of each line shows where the index closed. Notice that everything appears pretty even and regular until the Nasdaq peaked in July. Then those black vertical lines start growing longer, signaling much greater intraday trading volatility.

Most ordinary investors do not like volatility because it makes them uncomfortable. But it is important to understand that volatility is an inherent feature of the financial markets. We like volatility when it works in our favor. Most of us would be thrilled to own an investment that gained 5% in a single session. But when an investment we own loses 5% in a day, our feelings are totally different.

Volatility, risk, and reward are inseparably connected, even though most investors wish that were not the case.

As I write this, the Nasdaq is about 50 points (2%) higher than the prior week. But that isn’t necessarily comforting, because it is also 30 points lower than its close yesterday.

It is still too early to know whether this correction has reached its lowest point. But we can forecast with a high level of confidence that the markets’ are likely to maintain their increased volatility for several more weeks.

Enjoy the ride.
F.S.

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