Volatility Rears Its Ugly Head

With a blink of an eye another record run is now complete. February 5th marked the end of a historic run of limited volatility for the S&P 500. To be more exact, it was 405 trading sessions since the last time the S&P 500 experienced a 5% drawdown, the longest such streak since the index’s inception. After kicking off 2018 with an impressive January, markets erased all the gains in a matter of days. Volatility is back!

As I’ve written about repeatedly, we did not expect volatility to stay at such low levels forever. In fact, one of the major themes coming out of Allegiant’s Economic and Investment Summit at the beginning of January was an expectation for increased volatility in 2018. So far, that looks pretty spot on. Although it may be uncomfortable, an increase in volatility is not always a bad thing. A return to more normalized volatility is long overdue. 

Volatility is only one factor. More importantly, have the fundamentals changed? Nine years into this bull market, the most common question we consistently receive is why are stock markets so high? In reality, there are countless reasons why, but for purposes of this update, I’ll only focus on a few of the main drivers.

Economic Growth

The U.S. economic expansion continues, albeit at a pace slower than previous expansions. Make no mistake about it, the stock market moves in tandem with economic activity and a stronger economy is good for markets. Global economic growth is accelerating and investors are pricing in a continuation of this theme.

Corporate Earnings

Equity prices are directly tied to corporate earnings in multiple ways. Not only are today’s earnings important to investors, but projected earnings well into the future also play a role in how much investors are willing to pay today for a company. U.S. companies are experiencing a resurgence of earnings growth and investors have taken notice.

Interest Rates

Current interest rates also factor into how much investors are willing to pay today for future earnings. With low interest rates, investors are willing to pay more for future earnings. As interest rates (and inflation) move higher, investors discount future earnings at a higher rate and, therefore, are not willing to pay as much. This is particularly relevant considering the recent increase in market volatility, which is based partly on a quick uptick in interest rates. However, given current low interest rates, a market P/E of 20-25 times earnings is not unreasonable, as long as growth is accelerating. 

X-Factor

Finally, there is the x-factor, human emotion. The willingness of investors to buy stocks and the confidence investors have that stock prices will continue to move higher has a huge impact on equity prices. For years, stocks were under-owned by retail investors as expectations for future appreciation were low. However, as of this article, investor confidence about future equity returns is at an extremely high level. Translation: lots of money is flowing into equity markets, pushing prices higher.

Conclusion 

This helps explain why markets are where they are today. But, the more important question is where are they going from here? Unfortunately, no one has a crystal ball. At least, not one that works accurately every time. However, history teaches us one important lesson; just when conditions are at their best, we must begin to think about (and plan for) the eventual reality that growth will no longer accelerate. And, while economic conditions may still be good, markets will begin anticipating a slower acceleration of growth, followed by an actual decline in growth. This usually occurs during the later innings of an economic expansion and the team at Allegiant is continuously looking for signs of that turn, whether it be six months or three years out.

If you would like to see more data and charts about the economy and various financial markets please click here to view our Monthly Insights book, published online at AllegiantPA.com. 

Benjamin W. Jones, CFP?, AIF?

CERTIFIED FINANCIAL PLANNER?

Chief Investment Officer, Principal

Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance in no guarantee of future results. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. The Dow Jones Industrial Average is a price weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Russell 3000 is a market capitalization weighted equity index encompassing the 3,000 largest U.S. stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The Emerging Markets Index is a float-adjusted market capitalization index that consists of indices of 21 emerging economies. The CBOE Volatility Index is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The Shanghai Composite Index is a stock market index of all stocks (A shares and B shares) that are traded at the Shanghai Stock Exchange. The ISM Manufacturing Index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The Non-Manufacturing ISM Report on Business is a purchasing survey of the United States service economy, published by the Institute for Supply Management. Investments involve risk including possible loss of principal amount invested.