Tuesday, February 6, 2018

Markets Drop on Surging Volatility


What just happened? Stock markets reversed sharply over the last two trading days, interrupting an unprecedented streak of steadily rising markets and low volatility. While yesterday’s result was widely noted to be the largest single-day point drop for the Dow Jones Industrial Average, in percentage terms it wasn’t anywhere near historic proportions. Nevertheless, the declines hit all the major indexes and are significant enough to warrant an urgent assessment of the markets.

Although corrections in the U.S. stock market are not unusual, the speed and intensity of the downturn the past week is concerning to many investors. Our view is that heightened volatility will continue for the near-term, but that the global economy and stock markets will eventually recover without long-term damage.

We wrote that commentary in response to the “flash crash” of August 2015 when the Dow dropped 1,100 points in the first 5 minutes of trading. Investors who held firm after that day have seen the Dow increase 53%. We believe similar advice is appropriate now. Our positive outlook for 2018 was based on the expectation of synchronized global economic acceleration, strong corporate profits, and rising but still moderate inflation. These factors remain intact despite the market’s behavior. Economic data continue to support this view, which ought to reassure equity investors.

If the economy is strengthening, why did stock values drop so suddenly? It is impossible to untangle all the causal relationships, but we can highlight three primary factors. First, last Friday, a number of investors sold equities on the fear that rising interest rates would choke off growth. Second, the Friday selloff led to an increase in price volatility, exposing a bubble in an obscure volatility-linked derivative product, which then burst. Third, computer driven trading that reacts to market momentum fed off this sudden panic and drove markets down on Monday. Thankfully, on Tuesday, they stabilized and staged a strong recovery. (The Wall Street Journal has a good explanation (subscription required) of the mechanisms of that particular derivative and how it affected markets).

What should investors do now? First and foremost, we recommend they focus on long-term investment objectives and remember that asset allocation should be designed to blunt the impact of short-term events. This past week was a reminder that the period of calm and steady market gains of the past two years is the exception, not the rule. For example, in an average year, the S&P 500 Index will trade down 2% or more five days and down between 1% and 2% an additional 20 days (Bloomberg: These Kinds of Stock-Market Losses Aren’t That Unusual). Still, even if we can expect increased volatility, accelerating economic growth should lift corporate earnings and stock values. It is true that interest rates are not as accommodative as they were three months ago. Following this correction, however, earnings multiples are much more attractive. Some caution regarding inflation and interest rates is warranted. But at this time neither has risen sufficiently to hamper economic growth or corporate profits. We will continue to closely monitor inflation as well as actions from the Fed, bond yields, and quarterly earnings. We believe the worst of the selling is behind us and that investors should stay close to their long-term equity targets.

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