PMC Weekly Review - February 09, 2018
Market volatility has not been much of a topic lately, with consistently rising stock markets being fueled by solid economic data, expanding global gross domestic product (GDP) growth, strong corporate earnings, minimal inflation, and low interest rates. Volatility, measured by the VIX Index (aka the ‘fear index’), traded at an average of roughly 11 during 2017, which was 45% below its long-term average of approximately 20 since its 1990 inception, confirming investors’ complacency that global synchronized growth and the economic expansion would continue. In fact, the S&P 500 Index achieved something that has not been observed since the 1960s: fluctuating no more than 2% during any one day throughout all of 2017. Additionally, 2017 was the first year ever that the S&P 500 Index posted a positive return during every month. Furthermore, in October 2017, consumer sentiment rose to its highest level in 14 years, and economies around the world were all in acceleration mode. This all occurred during a year with significant headlines, which included the threat of nuclear war with North Korea, ongoing political drama in Washington, and broadly stretched equity valuations.
However, the headlines abruptly turned negative last week, as the major stock market indices around the world declined between 4%-8% in a matter of days. Ten-year interest rates spiked to 2.85% on Friday on the back of a strong wage growth report, bringing inflationary concerns into the forefront and sparking fears that central banks may tighten monetary policy faster than expected. Volatility in the stock market spiked, as the VIX jumped over 55% last week and another 115% on Monday, Feb 5, to close at 37. Investors are beginning to ask, Is this just a market correction, or is it something bigger?
A market ‘correction’ can be defined as a decline of 10% or more from recent highs in the major market indices, and are usually short-term events. They can last for a few days or a few months, but are less in duration and severity than a bear market or recession. Although markets have not yet closed at these levels, this latest activity is out of the ordinary for recent times, as US markets haven’t experienced this type of volatility in more than two years. Will stocks continue to slide, or is this just a revaluation?
The moving parts to this equation are relatively ironic, as it has seemed like nothing could go wrong during 2017: The economy seems to be in great shape, growth is accelerating around the globe, central banks’ policies are still relatively accommodative, and the US tax overhaul should spur continued growth as companies’ earnings rise. However, political worries, rising inflationary concerns, uncertainties around Federal Reserve policy, the speed of future interest rate hikes, and the end of a 30-year bull market for bonds are rocking stock markets and spooking investors in what could be the end of the current economic expansion. Although no one can predict what might happen next, investors should always be prepared for unforeseen turmoil in the markets.
Conversely, this current bout of volatility could actually be positive, bringing valuations back into check and allowing company fundamentals to shine through. Active managers are seeing this as a welcomed and long-awaited event that should present opportunities to find undervalued names. Additionally, active managers can position their portfolio away from overvalued names and into areas with more attractive opportunities that may benefit during the later stages of an economic cycle, thereby bracing the portfolio for continued volatility and exploiting any pricing dislocations that emerge. On the other hand, index funds, which have posted impressive returns during this bull run, yet lack the flexibility to make these positioning changes, may overexpose them to what has worked in the past (i.e., large cap technology stocks), resulting in significant weakness during a market correction.
Either way, investors should remember a few key tenets: What goes up, comes down; volatility is not necessarily a bad thing; and as quickly as markets can reach new highs (as they did many times in 2017), they also can reverse and reach lows just as fast. With these points in mind, maintaining a long-term investment focus can help weather volatility when it rears its ugly head.
Monica Sengelmann, CFA