The Return of Volatility

Last year was a year of record low volatility in the stock market. The S&P 500 index including dividends, for the first time, gained ground every month of the year[1]; the biggest peak to trough drop in the S&P was less than 3%[2]; and the VIX volatility index (also known as the fear index) declined over 20%, ending the year at about half its long-term average.[3]  Benefiting from this relative calm, the S&P 500 index, including dividends, rose 22% last year, 37% since the election 15 months ago, and over 375% since its low point in March of 2009. That was before last week, the worst week for the Dow Jones Industrial average in over two years, and before Monday’s record setting one-day drop of 1175 points.

The S&P 500 index fell 4% last week (2.5% on Friday alone), while the VIX volatility index rose 44%. On Monday the S&P 500 index dropped an additional 4.1%. These reversals were generally attributed to a stronger than expected January employment report, with the US economy adding 200,000 new jobs, and wages growing 2.9%, the fastest annual wage rate increase in nine years. These potentially inflationary indicators helped propel a jump in bond yields (the 10-year Treasury rose to 2.85% from 2.4% at year-end), and a 2,250 point (8.5%) drop in the Dow Jones Industrial Average between January 29 and February 5.[4]

These attention-grabbing developments naturally prompt the question of where the markets are going from here. While we are highly reticent to make market predictions, we are happy to share with you what we do know definitively about the current economic environment.  Some key statistics are presented below.

What this data tells us is that inflation, interest rates, and unemployment all remain (attractively) well below historical norms, while GDP growth is also slower than average, but significantly improved from the 1.5% annual increase in 2016.[6] The economic outlook thus appears relatively positive, with organizations such as Bloomberg and Goldman Sachs predicting there is a low risk (about 15%-20%) of a recession this year. [7] (We are much less reticent to share the predictions of others!) The International Monetary Fund projects that all of the major economies in the world will experience positive growth in 2018, and that global growth will increase from a healthy 3.7% in 2017 to an even stronger 3.9% this year. [8]

The valuation of the stock market (based on projected earnings) is more of a mixed bag. US stock prices started the year at a valuation level 14% above the average price earnings ratio of the last 20 years, while foreign stocks, particularly in emerging markets, appear considerably more attractively priced. Other valuation metrics place the US market at much more attractive valuation levels (such as a comparison of stock earning yields vs. bond yields), or significantly less attractive levels (such as the valuation of our stock market vs. the size of the overall economy).

In November, the world’s largest money manager, BlackRock, published its five-year forecast of asset class returns.  It would appear that these geographic valuation differences factored heavily into the forecast. BlackRock projects sub 4% annual average returns for the US markets, and 6% to 6.5% annual average returns for foreign markets.[9] The fact that all of these returns are well below historical averages suggests a relatively cautious outlook, likely due at least in part to an expected increase in interest rates that may slow future economic growth.

The good news for US stocks is that corporate earnings should get a significant boost from the well-publicized reduction of corporate tax rates that takes effect this year, and also by the relaxation of government regulations. It is also worth noting that the sell-off was triggered by a strengthening economy, as opposed to slowing economic growth. While large stock market downturns can be triggered by a variety of factors such as excessive stock valuations, energy price spikes, and aggressive interest rate increases by the Federal Reserve, the most common driver is a contracting economy, and that does not appear very likely at this time.

[1] Business Insider.
[2] JP Morgan Guide to the Markets, Dec., p.
[3] Market Watch
[4] Barrons
[5] JP Morgan Guide to the Markets (Y Charts for Fed Funds Rate).  The averages for the economic indices are generally for 50-60 years.  The averages for price/earnings ratios are for the last 20 years.
[6] US Bureau of Economic Affairs
[7] Goldman Sachs:  2018 Economic Outlook
[8] IMF
[9] Blackrock

2018-02-09T10:43:08+00:00