BY KENT SHAW, CFA
Is the recent stock market activity unusual?
The last few days have seen a dramatic increase in volatility in the equity markets. The increase is certainly dramatic compared to the prior year but it’s important to understand that the volatility is not uncommon in the context of all market history. Before this week, the S&P 500 Index, a representation of the 500 largest US stocks, had not fallen more than 3% in over 300 days. That is the longest streak of such low volatility in 20 years. In other words, the past year has been the exception and somewhat higher volatility is the rule rather than the other way around. To further put the recent price drop in perspective, the market, as measured by the S&P 500 Index, is roughly where it closed at the end of the first week in January 2018.
The US equity market is expensive by many measures and that fact makes us cautious and more focused on other indicators that may signal a weaker market is ahead. However, most of the other data we track suggests that market is still in good shape so we are maintaining our current level of investment and are using the volatility to purchase attractive stocks. There are good indications that economic growth and earnings growth for companies in 2018 will be stronger than expected which is supportive of equity prices.
What about rising interest rates?
Interest rates have been slowly marching higher which may have spooked some investors but, contrary to common belief, rising rates by themselves do not mean an end to rising equity prices. At the end of 2016, the 10 year US Treasury bond had a yield of 2.45%. As of yesterday, that yield was 2.79%. Compared to history, inflation is still very low, near 2%, but there are indications it is rising. It would be unusual for the economy to have higher growth without some increase in inflation. We are a very long way from the rampant inflation that existed in the 1970s. Historically, rising interest rates have occurred at the same time stocks rose if rates were below 4%. That is the case currently. Above the 4% level, rising rates tend to impact stock returns negatively.
What is the VIX and is it important?
The VIX or CBOE Volatility Index has been much in the news lately. A simple explanation of the VIX is that it is an index that measures the expectations for volatility that are currently reflected by the prices in the options market. It is often called the “fear index”. If option traders expect large moves ahead for stocks, both positive and negative, the prices of options begin to increase to reflect that higher expectation and VIX will rise quickly. Over the last 5-10 years, a number of tradable products have emerged that allow investors to effectively buy or sell this index and those products have contributed to the large changes in the VIX. Over Monday and Tuesday of this week, the VIX had one its largest increases in 10 years. Since late Tuesday, it has receded significantly. We have reviewed data going back 20 years and in the majority of cases, large increases and quick decreases in the VIX are followed by positive market returns over the following 6 to 12 months. In the meantime, however, we are likely to see more volatility.
The quick market drop has jolted many investors out of their slumber but there are many reasons to expect positive returns this year. Every day we review new information and consider it in context to determine if changes to client portfolios are warranted. At the moment, the answer is “no” but we will continue to be vigilant. Please know that we consider the care and stewardship of your assets to be our highest priority and are honored that you have entrusted us with that work. As always, please call if you would like to discuss these issues or anything else.