Week in Review
While minor volatility returned to the markets this week the S&P 500 managed to be about even for the week as investors followed political events in Washington, D.C. Interest rates were slightly lower with the 10-year U.S. Treasury declining in yield from 2.37 percent to 2.35 percent.
Volatility refers to the amount of uncertainty or risk around the magnitude of changes in a security or a market’s value. This year has been an extraordinarily calm year in the stock and bond markets. While there is always turbulence below the surface due to stock or sector-specific issues, on average the volatility in the markets was near 10-year lows. The VIX index, which measures the stock market's estimate of future volatility, is holding steady at a reading of 9. The long-term average is 20, and a higher number for the VIX signifies greater expected volatility to come.
Equity investors have been focused on earnings as well as the synchronized expansion of both developed and emerging economies the world over. While we are unsure what will cause a resumption in market volatility it will most assuredly make an appearance in the near-future and the cause is almost never what you think it might be.
The chart below is one that we use frequently in our annual economic outlooks as well as in our quarterly charts. It graphs the long-term returns of the market as well as the largest intra-year decline. Any blue line above the horizontal line is a positive return in the market. Conversely, any blue line below the horizontal line is a negative return. One striking thing about this graph which shows 37 years of returns is how often the market is up versus down with an average return of 10 percent. The other things to note are the red diamonds which depict the largest intra-year decline in the stock market. On average, the stock market declines 14 percent peak-to-trough in a given year. By contrast, the largest decline in the market this year has been between 3 percent and 4 percent.
This low volatility will not continue forever, and we expect to experience more volatility than investors have been accustomed to recently - and we suspect that it will feel worse than it actually is when it comes back.
Over the years, we have often used an analogy of turbulence while flying to illustrate this point to clients. Let’s assume you are on a turbulent flight that is bumpy from the start. You get used to the tumult and it becomes a minor inconvenience, with the flight attendants still bringing out the beverage cart. However, if we were to assume you were flying on a relatively smooth flight and halfway through the trip the plane hits unexpected turbulence which causes you to spill coffee all over yourself, it would feel like a rude adjustment. While this metaphor may seem dramatic, we like to set client expectations for what "normal" volatility feels like in periods of calm.
Takeaway for the Week:
- When normal volatility returns to the markets, it may feel worse than it actually is