Market Volatility Rises Again

Matt Wright, CFA® |

Most global stock markets had been on a rather astonishing run of low volatility since February 2016. Gains from stocks during this period were not unusually high for a bull market, they were just unusually steady and price dips were infrequent, small, and brief.

We advised in our year-end commentary just a few weeks back: "Please don't count on a repeat this year." Lo and behold, volatility among stock and bond markets around the world have spiked higher in the past 10 days. Our cautionary comments were not intended to be clairvoyant – we did not have any specific prediction of what the financial markets would do. We just know from history that calm markets can break without advance notice and for reasons that may not be obvious.

So what do we know about the recent action in the markets? The primary issue appears to be what is often called a "growth scare." As opposed to a recession, a growth scare is a concern that investors have when there is potential for the economy to become overheated, resulting in higher inflation. This causes interest rates to rise and bond prices fall, which then feeds into competing investments such as stocks, causing them to fall as well.

While the overall growth rate of the U.S. economy remains historically below average, the proximate cause of the growth scare is the very low level of U.S. unemployment. The job market has tightened considerably in recent years but is just now pointing towards the possibility of rapidly accelerating wages. While your first thought might be that rising wages sounds like a good thing, it certainly can raise the risk of inflation, which is a potential problem in the long run.

What is SWA doing about this market volatility? We're not actually doing anything different than we were before. Our primary stance is to make sure our clients were invested in a risk-appropriate strategy beforehand since we know that markets can't be timed. In addition, we use portfolio monitoring software that allows us to review client allocations on a daily basis and rebalance them when they have drifted far from their target weightings. In recent months, we trimmed stock exposure in many of our client accounts due to the healthy gains we'd seen up until the end of January. Maintaining the target allocation on an ongoing basis helps to reduce downside when the risk inevitably shows up.

And speaking of risk, our view is much more focused on avoiding permanent losses than intermittent ones than can be recovered. Because of that, our investment choices could be accused of being too boring at times. We aim for what we consider to be reliable long-term growth vehicles and stay away from unproven and/or speculative opportunities that may be highly rewarding but come with excessive risk. For example, a hot strategy in recent years of buying "short volatility" products has cratered in the past week. One product that had phenomenal returns as recently as last month had a breathtaking drop of over 95% in a single day. Investors (gamblers) who had made "easy" money in the past learned that it was a little harder than they thought. SWA does not believe a little extra upside is a good trade for a whole bunch of downside.