Investment Planning Series - Thoughts on market volatility
Surely many Financial Advisors will be getting some questions about recent market declines (February 5 alone the S&P 500 was down over 4%1) and hearing from their investors who are nervous about their investment portfolios.
This time around, it’s very difficult to pinpoint a single overarching reason for the declines we’ve seen over the past week or so. One common reason seen in a lot of articles right now refers to the recent employment report, which showed strong wage growth. The rationale being that it means inflation is higher than expected, which could lead to an interest rate environment being higher than investors have been expecting. Higher rates means higher borrowing costs for companies, higher discount rates in asset pricing models, less accommodative central bank positions and actions, and safer assets (like Treasuries) are relatively more attractive because they offer higher returns when yields increase.
The underlying reality of this, however, is that the economy may also be stronger than expected. Higher wages generally mean workers have more money that they are able to spend buying goods and services, which is positive for economic growth. Also, too-low inflation is not necessarily a good thing and the inflation backdrop has not been as firm as the Fed would like to see recently. Inflation that is a little stronger, particularly if it coincides with higher wages, seems like a good thing. So, the recent selloff is hard to reconcile with economic fundamentals because stocks have pulled back as the economy looks stronger. Typically, a broad equity market selloff out of fear may be accompanied by lower Treasury yields (higher prices for Treasury bonds), which has not happened.
Another explanation for part of the magnitude of the declines recently is that computerized trading programs were triggered as stock market levels fell below certain thresholds. This is a somewhat “newer” factor that has the capacity to drive markets in the short-term as algorithms and automated trading programs react to news and volatility. As high-frequency trading has played a significantly more prominent role with respect to share of daily stock market trading volume, it makes sense that the capacity exists for larger and faster swings in stock prices, particularly if the assumptions underlying automatic trading programs are stressed or change. This likely plays a part in periods of increased volatility. In addition to high-frequency trading though, many institutions use computerized trading programs to sell stocks if certain criteria are met in order to, as they see it, prevent further losses or to offset the specific risks that institution faces.
The stock market has been exceptionally strong up until this point (the S&P 500 still has a total return of just under 18% over the past 12 months2) and volatility has been at historic lows, so stock market pullbacks are totally healthy and are to be expected. While not even close to the largest single-day percentage declines in history, a 4% plus one-day decline is certainly well above average. The good news is that the US and global economies seems strong, which is a supportive environment for stocks. Investors should absolutely expect more volatility than we have seen for several years now and, while no one knows for sure, it’s always possible that this may be the start of a return to normalcy in the stock markets, where 5-10+% pullbacks are normal and healthy. For investors that have cash to invest, it could be an opportunity to put some cash to work, although we certainly don’t know whether to expect further declines or if stocks will bounce back in the short term and how quickly.
1 Yahoo Finance
2 Morningstar Advisor Workstation
S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market. Investors cannot invest directly in an index. Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the view of Capital Analysts or Lincoln Investment.