Volatility returns to markets

More normal trading patterns likely to emerge

Volatility returned to the stock markets, seemingly very suddenly, at the beginning of February. It was hard to avoid panicky headlines shouting about the 1,175-point drop in the Dow Jones Industrial Average on Monday, Feb. 5. Some are already calling it “Black Monday.” All the other major stock indexes followed suit. Toronto’s benchmark S&P/TSX Composite Index fell 271 points. And the broader U.S. blue-chip S&P 500 Composite Index fell 113 points. At one point during the week, several indexes briefly entered “correction” before recovering somewhat. Is it a “crash,” a “correction,” or a “healthy” revaluation? And what – if anything – should you do about it as an investor?

So let’s step back from the hyperbolic daily news reports for a moment and look at what might really be going on here.

First of all, stock markets have been in an uninterrupted bull market since January 2016. That’s two years without a significant pullback or correction. Through the period, economic growth has continued to improve, and corporate earnings both in Canada and the U.S. have grown steadily. In fact, earnings among S&P 500 companies in the U.S. have grown at double-digit rates recently. All the while, unemployment has remained low – very near the “full employment” level in the U.S. – job creation has been robust, inflation has been contained, and perhaps most importantly, interest rates have remained very low.

It’s important to note that none of these underlying fundamental macro-economic indicators has changed in the past week or two. In fact, the yield spread between short- and long-term U.S. Treasury notes (the so called “yield curve”) remained well within normal limits. Last Monday, the yield spread between 2-year notes and 10-year notes was 69 basis points. That’s 18 basis points higher than it was at the end of 2017.

Why is that significant? The yield curve is an unfailing barometer of trouble in the broader economy. When it becomes “inverted” (that is, when short-term yields are higher than long-term yields), the yield curve has never failed to predict an imminent recession, closely followed by a stock market correction or crash. This simply is not happening right now. There is no recession imminent. And the stock market declines of recent days really can’t be characterized as a “crash.” The investor panic associated with crashes just isn’t evident. Liquidity is good, market trading mechanisms haven’t frozen, and safety valves haven’t kicked in.

What is happening is that market expectation of the direction of interest rates have changed. The Bank of Canada had already raised its benchmark policy rate twice in 2017 and hiked it again in January, for a cumulative rate hike of 75 basis points, to its current 1.25%. Other central banks have also been making hawkish noises, especially the U.S. Federal Reserve Board, where the new Chairman, Jerome Powell, who just took over from Janet Yellen, is an unknown quantity.

Bond yields have been rising steadily since last fall in anticipation of impending central bank rate normalization moves. And higher interest rates eventually figure into stock value calculations, as borrowing costs of corporations increase. Stock valuations have been extraordinarily high, with the recent price-earnings ratio for the S&P 500 Composite at over 24, well above the mean of about 16. A correction from such lofty levels (the so-called “reversion to the mean”) is inevitable, and this may be just what’s happening now.

By the end of this week, the S&P 500 had dropped 10% from its recent high, which is traditionally defined as a “correction.” Toronto’s S&P/TSX Composite dropped 8% from its recent high, also getting close to correction territory. Additionally, implied volatility of the S&P 500 as measured by the CBOE Volatility Index (VIX) spiked to about 40 after resting complacently at around 11 through 2017. It subsequently fell back to just below 30.

A drop of 20% from recent highs is considered to be a bear market. We do not believe the market will sink to bear market levels, mainly because of the undeniable strength of the underlying economic fundamentals. However, we are likely to continue experience more normal levels of market volatility, which isn’t entirely unwelcome, as it improves trading opportunities as valuations return to more normal levels.

Our advice is to stick to your investment plan. The silver lining to the current bout of market volatility will be found only if you stay invested in a well-diversified portfolio. Fear is always the impetus for bad investment decisions. As long as your investment objectives remain intact, you’ll be able to comfortably ride out this level of market volatility and more. And you’ll be able to snap up bargains as they appear (and they always do when market sentiment swings to extremes).

© 2018 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

Volatility returns to markets was last modified: February 12th, 2018 by robyn