More On Volatility
As we mentioned in our March comment,
we expected stock market volatility to increase this year and it has. The low volatility experienced in 2016
and 2017 lulled many investors into believing low vol was here to stay. This
was not to be the case, nor could it be. Market “corrections” (downward moves
of 10%-20%) have historically occurred on average about once a year, while
market “adjustments” (downward moves of 5-10%), have historically occurred
about 3 times a year. To not have not a downward move of even 5% for a period
of about 21 months (March 2016 to December
2017) was not only a record, but entirely unsustainable.
What has contributed to the
increased volatility this year? Several factors: concerns over Federal Reserve
policy, concerns over rising inflation, concerns over the potential for a trade
war with China, and more recently, increased legal troubles for President
Trump. We believe the concerns over Fed policy and inflation have been
overblown. The Fed continues to maintain a steady and well telegraphed interest
rate policy and, absent a dramatic acceleration in inflation (which we do not
expect), we believe Fed policy should not lead to damagingly high interest
rates. With regard to inflation, we had some good news in the April payroll
report in which the pace of both job creation and wage growth cooled off from
previous readings. Wage growth of 2.6% is in line with the long-term pace
during this recovery and we believe does not have inflationary implications, at
least as of now.
With respect to the potential
of a trade war with China, we believe investor concerns over this issue are
justified; however, we believe a more probable outcome is that China and U.S.
will ultimately reach some reasonable and mutually accommodative position. We
believe China understands there has to be more of a balance in trade with the
U.S. to sustain a positive long-term relationship and access to vital U.S.
markets. With respect to Donald Trump’s legal problems, it is difficult if not
impossible now to predict an outcome or ending for this. Uncertainty around any
country’s executive leader is problematic for the market and we expect this
issue could continue to contribute to market volatility in the near term.
What’ the point? So the point about this rather dry analysis is to put recent stock
market volatility into context. We have heard some concerns from clients about
the recent volatility. We want to assure clients that a) volatility is normal,
b) we understand what is causing it, and c) we believe underlying economic
fundamentals remain favorable for stocks. We often get the question “should I
pull my money out til this is over?”….. in other words, try to time the market?
We have long understood, and studies show, that market timing is difficult if
not impossible. One interesting statistic on this: according to BTN Research,
the total return for the S&P500 over the past 10 years has been 8.5% per
year. If you missed the 10 best percentage gain days over this period, the
return drops to an annual gain of 1.3%. There will be periods of variability,
some more violent than others. Trying to time the ups and downs of the market
will almost always lead to disappointment and lower long-term returns. With
regard to investing, it is important to keep volatility in context, maintain a
long-term view, and adhere to a disciplined investment process.
Despite the recent
volatility, we remain constructive on stocks. Valuations based on forward
price/earnings for stocks remain reasonable and about in line with the
long-term average (about 16x), so stocks are not overvalued. Valuation is the
single most important factor in determining long-term stock returns. While
there is some concern about a peaking in earnings growth in 2018 (also
contributing to recent volatility), we believe it is likely that even if earnings
growth slows, which it will, corporate cash flows should increase significantly
in 2018 and 2019 as a result of the tax bill. As corporations return this cash
to shareholders, we expect a lot of it will get “recycled” into the stock
market, thereby providing fuel for higher valuations and stock prices over
time. Another way of looking at it is we expect investors most likely would pay
up for stronger and perceived sustainable cash flow.
Robert Toomey, CFA/CFP
Vice President, Research 
