HOW TO UNDERSTAND VOLATILITY IN THE STOCK MARKET
The fourth quarter of 2018 was a reminder that financial markets can go both up and down. Some days we saw the Dow Jones Industrial Average swing 1,000 points in both directions — up and down and down and up. We also saw the CBOE Volatility Index, the market measure of potential volatility, increase from 12.12 on Sept. 28 to 25.42 on Dec. 31 — a whopping 100 percent increase.
Both professional market participants and retail investors have been left wondering what happened, and why. Last year started out with much excitement over the prospects for corporate and individual tax cuts and a more relaxed regulatory environment. The promise of renewed growth in America’s domestic economy pushed price-to-earnings ratios higher, and market momentum was on the upswing. As positive economic news was reported and we received growing IRA statements, all was good with the world and there was no end in sight for the country’s “aging” bull market.
Of course, the old sayings are true: Nothing fails like success, and what goes up must come down. The economy today is facing a good deal of uncertainty. Here’s what has changed:
First, the Federal Reserve’s Federal Open Market Committee has had an impact on interest rates and liquidity in financial markets. The U.S. Treasury interest rate curve has continued to flatten, and at certain times invert, as the FOMC has moved the Fed Funds rate higher. And the process of reducing the size of the Fed’s balance sheet, thus dramatically reducing liquidity in the debt markets, is impacting both the pricing and availability of buyers of both public and private debt instruments. Remember that through the quantitative easing program, the Fed’s balance sheet grew from $870 billion to $4.5 trillion in September 2017. Thanks to the quantitative tghtening process, they are no longer the major buyers of both U.S. Treasury bonds and long-dated agency securities.
Retail investors also must acquaint themselves with both the ups and downs of “passive investment” vehicles. Electronically traded funds have become a very popular investment alternative over the past 10 years, thanks to the bull market. ETFs are constructed to mirror the market, and they are designed to match certain market indexes without the need for “active” management — so they’re able to charge smaller fees than traditional mutual funds. To me, index-based ETFs are no more than a reflection of momentum in the markets. As more dollars flow into passive ETF investments, the ETF sponsors are forced to be buyers, pushing markets higher. When events force the markets to adjust downward, buyers begin to look for safety and outflows from ETF investments multiply the downward pressure on the market.
What kind of events can affect the market? Clearly there are both domestic and global uncertainties out there that will undoubtedly influence both equity and fixed-income markets. Globally, we need to be concerned about the impact of Brexit on the European Union and the overall economic slowdown led by uncertainty about the financial health of European banks. There is also an economic slowdown underway in Asia, but we also need to fully understand the potential impact of a full-fledged Trade war that could develop into a cold war. That would have major global implications both politically and economically. We must also watch the price of oil; low oil prices could impact geopolitical events in the Middle East, where America’s influence is beginning to wane.
Domestically, the greatest potential risks are political. A divided government doesn’t necessarily indicate bad news, but disruption caused by politically charged congressional hearings can create additional uncertainty for markets — and we’ve already seen consumer confidence decrease month over month as consumers become rattled by market volatility. Then, of course, there’s the matter of America’s growing national debt and whether the country can find new buyers for U.S. Treasury securities. Typically, countries like China, Japan and Saudi Arabia have been the largest buyers of U.S. debt, but no more. Demand for these securities can have far-ranging impact, including on Fannie Mae and Freddie Mac mortgage-backed securities, which can influence housing affordability.
I also believe the evolution of computer-based trading and an influx of inexperienced money managers are a big risk to the equity and fixed-income markets in 2019. Computer-based trading can certainly bring efficiency to the investment process, but algorithms used by these trading programs are quantitative by their very nature. My experience tells me that outperforming the mean return requires the value derived from qualitative human intervention. And, of course, it helps if those humans have extensive experience, which is why I’m worried about the new crop of money managers entering the market today. The financial world of 2019 and beyond will be significantly different from the one we have experienced since the mid1970s — we are likely to enter a prolonged period of rising interest rates and above-trend inflation. Portfolio managers who have seen this kind of market would have to have been born before 1955 to have that real-time market experience, and there are far fewer of us headed to the office every day.
So how can you weather 2019 with your nest egg intact? Don’t overreact to daily market noise. Stay well-diversified, and don’t be afraid to rebalance your portfolio regularly. Most importantly, hire a smart — and experienced — financial adviser.
Elihu Spencer is a local amateur economist with a long business history in global finance. His life work has been centered on understanding credit cycles and their impact on local economies. The information contained in this article has been obtained from sources considered reliable but the accuracy cannot be guaranteed.