Volatility: Back to Normal!

BY: Mark Drachenberg

Last month I asked if you were feeling a bit frazzled.  If you weren’t then, you probably are now.  February was the first month in well over a year where the equity markets were negative and the ride down was a wild one.  Since no one expects the markets to move higher every month that is hardly surprising, unlike the return of volatility.  The average reading on the VIX (a measure of implied volatility for the S&P 500) was just 11.8 over the last year or so but February saw the reading spike to almost 38 before falling back to below 20.  Generally speaking, readings above 20 are considered periods of heightened volatility while readings below 20 imply low volatility.  The reading currently stands right around 20 but has been bouncing around that number for several days.  While recent data suggests this is a period of heightened volatility, we are not far off of long-run averages so, like it or not, we are back to normal!  The increase in volatility and the recent correction in stock prices have left many investors scratching their heads wondering what has changed over the last six weeks and how they should deal with it.  First, the markets and then we will try and deal with these issues.

February was rough on investors and it didn’t really matter if you were an equity or fixed income investor.  All the major indexes we follow fell and at least some turned negative year-to-date.  The shining star is the tech heavy NASDAQ that was still up 5.54% at the end of February.  Fixed income investors also felt the pain as the threat of higher interest rates spooked investors causing yields to rise but prices to fall.  See below for more information.

So what triggered the uptick in volatility and the ripple effect throughout the equity and fixed income markets?  It started with a jobs report in late January that noted that wages had ticked higher than expected and an inflation report that also ticked higher than expected.  Speculation ran rampant that the Fed would now raise rates more often, and perhaps higher, than previously expected.  This meant a likelihood of four rate hikes in 2018 instead of the previous expectation of 3 (we have been saying this for some time).  The equity markets prefer lower or at least stable rates and certainty vs. uncertainty and these reports only added more uncertainty to the equation.  At the same time, Janet Yellen was replaced by Jerome Powell as Fed Chair.  Adding fuel to the fire were his comments before a House of Representatives sub-committee where his stance was more hawkish than dovish.  While he, and others, have stated that whatever action the Fed takes will be based on their assessment of the economy, investors remain concerned that rates will move higher faster.  So, interest rates and inflation were a cause but the fact that the equity markets were due for a correction helped fan the flames.

The correction finally happened on February 8th as equity markets lost 10% from peak to trough and have gyrated since.  Investors have been increasingly skittish about the level of the equity markets and how sustainable prices are.  While the drop in prices hasn’t meant that the markets are undervalued by any means, based on future earnings expectations they are much closer to fair value.  The problem is that returns will likely be muted and fall somewhat closer to long-run averages, at best, over the next year or so even with the strong earnings outlook.

Several issues remain front and center in our eyes and these are inflation, including the general level of prices and the growth in wages, the Fed and how fast and how often they raise rates this year, and lately the heightened potential for a trade war since President Trump announced new tariffs on steel and aluminum.  All of these, and more, will dominate the economic news and all will likely add to the volatility we see in the markets.  The good news is that we do not expect them to lead to either a bear market or a recession this year.  For now, several factors that influence the economy are still very strong including the consumer credit environment, consumer confidence, robust capital spending by corporations, and an accelerating manufacturing index.  Inflation still hasn’t run wild and is not expected to do so, at least in the short run, but any uptick will add to the skittishness investors feel.  Finally, corporate earnings are expected to grow at their fastest pace since at least 2011 which could help cushion any downward movements.

A quick look at some statistics may provide some background to volatility’s return to normal.  First, the equity markets normally face a 5% pullback at least three times per year and we didn’t see one for well over a year.  The markets face a correction of 10% or more at least once per year and our last one was in February of 2016.  Finally, we normally face a bear market once every three years or so and our last one (based on closing prices) was during the great recession.  So, painful I know, but due, yes.  This sometimes leads investors to want to bail out on their holdings and move into less risky investments.  That doesn’t always lead to the best results over the long-term as data from J.P. Morgan shows that by staying fully invested in stocks (S&P 500) over the period of 1997 thru 2016 would have provided a 7.68% return while missing the 40 best days would have meant a return of negative 2.42%.  Key here is that 6 of the 10 best days occurred within the two weeks of the 10 worst days.  In fact, missing just the 10 best days would have reduced your return to just 4.0% as well.  This period included the great recession and the extreme levels of volatility we saw then and the reduced levels of volatility we have seen since.

We recognize that we are in a news driven environment now which can be typical in a late (economic) cycle environment.  Volatility increases as investors pay more attention to news items and react faster than otherwise.  This can be a great time to tune out the news, focus on fundamentals, and keep the long-run in mind.  As investors we have expected a return of volatility and a correction at some point this year and so are not surprised by current events.  We reiterate that this will be a year where a balanced and diversified approach will pay off more so than specific and large asset allocation bets.  As always we continually monitor economic reports to help guide us in our decision making and will take appropriate steps as conditions warrant keeping in mind both client specific issues and the long-run investing environment. 

If you are concerned over current market conditions or haven’t had a formal review in some time, now would be a great time to stop by our office in Madison or call our Wealth Management department at (608)826-3570 to schedule a portfolio review.

As of February 28th, 2018…..  

Dow Jones Industrial Average up 1.69% YTD                         Barclays U.S. Agg. Bond Index down -2.09% YTD

S&P 500 up 1.83% YTD                                                                  EAFE up 0.05% YTD

S&P 400 down -1.69% YTD                                                      Inflation (CPI) 2.1% (as of January 31st)

S&P 600 down -1.44% YTD                                                           Unemployment 4.1%

NASDAQ up 5.54%

Thank you for your business – we look forward to speaking with you soon.  (Note – this commentary used various articles from Morningstar, the Wall Street Journal, Investor’s Business Daily, Northern Trust, CNNMoney.com, msn.com, Kiplingers.com, nytimes.com, Fidelity Investments, American Funds, LPL Financial and other tools as sources of information)

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