Focus: Recent Market Volatility - More Downside Momentum Ahead?
Early in January, during a meeting with one our clients, when asked for my outlook for 2018, I cautioned that expectations should be toned way down. I also mentioned that we would likely see considerably more volatility going forward.
With Buffett’s well-worn adage of being “fearful when everyone else is greedy” ringing in my ears, I felt strongly I was right, but sometimes, you don’t want to be that right.
So, what was the data telling us three weeks ago, and more importantly, what is it telling us now?
In the last 90 years, there have been 303 market dips of between 5% and 9%, which means that, on average, there are 3.4 occurrences in any market year. Therefore, you can reasonably expect a dip every 100 days or so.
By February 2nd, when our recent market volatility began, we had gone 400 days without such a dip. The all-time record was set on August 3, 1959 at 409 days - we just missed breaking a new record!
In the 24 months leading up to February 2nd, only 2 months had recorded negative returns. We had just been through one of the least volatile periods in market history.
Back in the beginning of the 2000's through to the financial crisis, 5% corrections were very common. Yet, because of recent history, this current level of volatility feels much worse than it really should.
The U.S. economic engine - in addition to a good portion of the global economy - is still in growth mode. Industrial production is up and leading indicators are on the rise. There aren’t any signs of economic stress, no huge warnings signs from market top or bear-watching indicators. The data does not suggest an imminent recession on the horizon, despite fears around the interest rate spike and potential inflation that likely created some of this recent volatility. This is important because major bear markets usually happen in conjunction with recessions - perhaps not every single one, but most - and it doesn't appear that such a recession is on the horizon.
While economic indicators aren’t showing signs of stress, price indicators have come under some pressure. Our models are still leaning bullish at this point, with no red flags being waved, and no panic button rising from the desktop.
Even with the spike in interest rates, and the expectation that more will follow, I would chalk the recent volatility up to two forces:
Fear - always a big mover and shaker in the markets. Fear around higher interest rates. Fear that inflation will force the Fed to accelerate their activities, leading investors to reassess their post-financial crisis regime of Fed accommodation and relative valuation to stocks.
The increased popularity of exotic ETFs and trading instruments that have a large amount of implicit volatility baked into them. These vehicles often make short-term market moves worse, and can cause them to play out more rapidly.
This second force, may in fact be “the real culprit” behind the decline. Many of these vehicles involve leverage, and the unwinding of that leverage combined with machine and algorithmic trading have a huge impact on the volatility of a market that’s moved into pullback territory.
An investor in one of these vehicles who has set a target volatility level on an index, can be forced to sell and move to cash due to increased volatility without any forethought or consideration. Massive moves by vehicles like these, where there are large numbers of investors whose trades are being made by formula rather than advice, can create rapid sell-offs across the entire market - something that occurred on February 5, when the Dow dropped 900 points in 10 minutes.
There’s simply no way that this happens to an average human investor making considered trades. We all need to be careful about the decisions we make when markets make big moves, especially in an environment with new vehicles that can change how the system works at its core.
Returning to market history, in cases where there has been a pullback of 5% or more, after a long-term rally in the markets much like the one we’ve had, the average return 12 months later is positive. Historically, we move from peak to trough to peak in a year.
Recent volatility, however disconcerting, has shifted the market from an overbought condition to now being oversold. Pessimism has increased, but valuations, which we’ve felt were high for some time, have improved with this change. Indicators across the board are calling for economic growth, and a continuation of a cyclical bull market - one that may be simply returning to normal volatility after 400 days of unusual calm.
- Greg Stewart, CIO