June 2018 Market Update
Written by Brian Johnson, CIO
Summary: We’re watching volatility levels carefully, as they are a key indicator that a correction may be afoot in equities markets. At present, volatility is elevated but not alarmingly so.
The historically low volatility in equities markets that we experienced in 2017 has, as expected, returned to “normal” in 2018. Those who keep a watchful eye on the markets may have noticed confirmation of this in the increased range of the daily price swings. What had been considered a large one-day price swing last year is now seen as common place. In fact, one need not watch price movement on a daily basis to track the market’s real-time expectation of volatility. A tool exists, the S&P 500 Volatility Index (VIX), to monitor volatility more directly. The VIX spiked meaningfully higher in early February, and, though off its peak, is still above the levels it maintained for much of 2017.
Why is tracking volatility important? Volatility is a leading indicator, and before a bull market morphs into a bear, we typically see extended periods of low volatility give way to periods of higher volatility and increasing threat of economic downturn. That, in turn, ultimately causes stock markets to correct.
Our partners at Ned Davis Research have us currently watching what they consider the two most likely “shot across the bow” candidates causing a rise in volatility, and warning of a more significant impending market correction.
The first candidate would be an earnings-driven pullback, which would be fueled by disappointing corporate earnings. Given the increasingly high correlation of tech sector earnings and stock performance to the performance of equity markets on the whole, a slow-down in technology sector earnings would be cause for concern.
The second candidate is one that we’ve had clients asking about for some time, and that is an interest rate driven pullback, in which equities fall as the correlation between stocks and bond yields flips from positive to negative. Historically, equities have trended higher until the interest rate on 10-year Treasuries reaches 4.5% – 5%. Unfortunately, there is no historical precedent for interest rates following years of quantitative easing (QE) in response to the Credit Crisis and “great recession,” so it is hard to know if that same rate range will still apply.
Both of the above candidate scenarios are likely to occur in a similar economic/market environment. Specifically, they both involve a deteriorating outlook for the economy that triggers lower stock Price-Earnings (PE) multiples and a market pullback.
So… we’re watching volatility carefully as an indicator that the market is increasingly concerned with deterioration of fundamentals. Of course, volatility levels are also useful as an indicator of whether or not the bull market is likely to continue higher. If high volatility levels are a warning sign of a possible correction, a move higher in equities coincident with calm volatility suggests confirmation that the bull market is likely to continue.
As always, it’s important to note that every investor’s situation is different. Goals vary, as do investment time frames. Whereas a well-paid 35-year-old who is saving for retirement should view a bear market as an opportunity to buy stocks “on sale,” a bear market may impact a retiree struggling to make a mortgage payment much differently. That’s why we develop financial plans according to your goals, and allocate your money accordingly. If you ever feel that your investments might be out of alignment with your goals, please give us a call.
Lastly, please enjoy the 4th of July holiday. It’s my favorite holiday every year, as it’s hard to beat gathering with family, small-town parades, warm weather, fun-runs, BBQ’s and fireworks.