Volatility Is Back!

April 18, 2018

2017 was one of the least volatile periods on record for the stock market. S&P 500 had a positive return every month and the largest decline during the year was 3%. Near perfect investing conditions with global synchronized economic growth, low inflation, strong earnings growth, deregulation, and low interest rates conditioned investors to indiscriminately buy equities without fear, propelling stocks to historic levels throughout the year without much volatility.

The start to 2018 felt like a continuation of 2017. S&P 500 gained nearly 6% in January, making it the best January performance since 1997.  The climate abruptly changed the next month when volatility came roaring back. On February 5th, the Dow Jones index dropped 1,175 points, making it the largest daily point loss in history. Three days later, the index had the second largest daily point loss in history, dropping 1,032 points. Financial headlines like “biggest one day drop in Dow’s history” started to dominate the media. Optimism and bullish sentiment quickly turned toward fear and doubt. In less than two short weeks, the stock market had its first 10% correction in two years.

The global economy and corporate earnings remain on firm ground so what was different in February to cause this sudden change?

A major factor was the shift in investor sentiment. Investors have been spoiled by easy monetary policy and low interest rates for almost a decade as the Federal Reserve nursed our economy back to health.  There is now fear that 2018 could truly be the beginning of the end of quantitative easing given the strength of our economy. As a result, interest rates may rise more aggressively than anticipated. The Federal Reserve has been very clear about their intentions and plan to methodically tighten monetary policy, believing the economy is strong enough to absorb the slack.  Only time will tell whether or not they will be successful in doing so.

The stock market has also been on an incredible run since 2009 and valuations were above average.  As a result, investors took profits and rebalanced portfolios in the beginning of this year. To compound the selling pressure, computer driven model portfolios were forced to sell stocks when certain levels of the stock index were reached or when volatility spiked. Lastly, the markets were rocked by fears of a global trade war breaking out when tariffs were announced in March.

Many investors have become used to low volatility in recent years and have forgotten how normal volatility is. Market declines are common and occur frequently. In this current bull market alone, there have been five corrections, and since World War II, there have been over 36 corrections. Market declines are healthy and help keep euphoria at bay.

Despite strong corporate earnings and positive economic data, we expect volatility to continue throughout the year. The ups and downs of the stock market can be unnerving, but volatility is the price investors have to pay for higher long-term returns.