Understanding Market Volatility
December 13, 2018
Ann Terranova, CFP®
Whenever the stock market exhibits increased negative volatility, it is natural to be concerned. We need to understand that market declines are as natural as market increases so that we can continue to invest with confidence. At the same time, understanding what is happening in the economy, cycles of growth and recession, and government policies is important, even if it doesn’t lead to changes in personal investment policies.
Here are some charts. This is the S&P 1-Year Chart. You can see the downturn that began at the end of January, recovery in April and the most recent downturn in September.
By comparison, this is the S&P 5-Year Chart. This chart can put the failure in 2018 equity returns into a longer-term perspective.
Here are the percentages for the two major drops during the year.
Reasons for Market Volatility
Three are many reasons being cited for the market volatility occurring this year. Generally, the reasons cited for this volatility include:
⦁ Trade Tensions/ trade dispute with China
⦁ Geopolitical uncertainty
⦁ Buildup of corporate debt
⦁ The Fed’s own rate hikes
⦁ Inversion of the Yield Curve
⦁ Slowdown in the housing market
⦁ General fears about declining profit margins, slowing growth
⦁ Fears of a recession
I’ve grouped these topics into three: Inverted Yield Curve, Fed Policy, and Other.
Inverted Yield Curve
Wall Street has suddenly begun chattering about a yield curve inversion, which happens when long-term interest rates—typically, Treasuries—fall below short-term rates. Interest rates are largely driven by market conditions, and long-term rates are normally higher because the risk of holding the debt over a long period of time is greater than the risk for short-term debt. But when long-term rates fall below short-term rates, that suggests borrowers expect a weak economy over the longer term, and usually, they’re right: a yield curve inversion has preceded every recession since 1957.
This chart shows the difference between rates on 10-year Treasuries and 1-year Treasuries, with the shaded areas indicating recessions. When the difference is less than 0, that means short-term rates are higher and the yield curve is inverted.
Long- and short-term rates have been converging this fall, with the curve flattening, as the chart above shows. The yield curve inverted officially on Tuesday, December 4th, with respect to the 2-Year and the 5-Year Treasuries. The big inversion, though, is between the 2 and 10-Year Treasuries, and that hasn’t happened yet.
Generally, the inverted yield curve is considered a harbinger of a recession, that the economy is poised to weaken. But is that necessarily the case? No. An inverted yield curve can be a false alarm. The difference between 10-year and 1-year Treasury rates went negative in 1966, but no recession ensued. The curve became positive again in 1967. It inverted again in 1969, and that time, the warning was real: a recession began in December of that year.
In order to accurately anticipate the economy, you have to know a lot more than the fact that the inverted yield curve is signaling a weak economy to come. When will this recession happen? How long will it last? How deep will it be?
The stock market declines also signal the potential for a weak economy to follow. But these events can play out in time and with variations that make the general alignment useless from a predictive or market timing standpoint.
This chart shows the S&P 500 returns superimposed with the grey bars marking recessionary periods. As with the inverted yield curve, there are false signals and significant timing variations.
Still the inverted yield curve is an important factor in understanding where the economy is right now.
Bank stocks sharply declined, and this makes sense. A normal curve with the two-year offering a lower yield than the 10-year is fundamental to how banks make money. Banks borrow short term at lower interest rates so that they can make long-term loans to borrowers at higher interest rates. The difference between those two interest rates, the positive spread, is their profit. If a bank is borrowing short term at a higher interest rate and making loans to borrowers at a lower interest rate, the difference is a negative spread.
In this interest-rate environment, banks would lose money by making loans. Not necessarily on all loans, but it does make some loans unfeasible and some less profitable, forcing banks to cut back on making loans, thereby choking off the access to credit markets that businesses need to grow. This then fuels the slowing of the economy, potentially enough to be a recession. A recession is generally considered negative economic growth for two consecutive quarters.
It looks more like the official inverted yield curve, 10-Year rates falling below 2-Year rates, is going to occur, but it still has not happened yet. There is still a risk of the big inversion. I would say we are perilously close. What could stop the collision course between the two-year and 10-year rates?
The Federal Reserve could stop raising short-term rates. More on this in the next section.
For the individual investor, it must be an acceptable risk that recessions — and the bear markets that are associated with them — will happen many times over the course of one’s lifetime. This is exactly why risk tolerance needs to be adjusted lower as one ages. Your investment portfolio should take into account how many working years you have left, if any, and you should adjust your asset allocation, not to accommodate changing economic conditions, but to match your changing personal circumstances.
Federal Reserve Interest Rate Hikes
A key driver of the recent market decline is that expectations have been growing that the US Federal Reserve will continue raising short-term interest rates. Until as recently as September, interest rate hikes by the Federal Reserve were widely anticipated to continue through 2019. But now, many are calling for a “pause” in interest rate increases.
Fed Chairman Jerome Powell was responsible for some of the change in tone after he said the fed is “close to neutral” on Tuesday, Dec 4, contradicting a comment he made in early October that “neutral is a long way off.” Neutral is the level that would no longer be stimulative or slowing to the economy.
Powell’s comments last week, saying rates are close to a range of neutral estimates pushed the market higher on the belief the Fed would not raise as often as the market had been baking into its outlook. It is believed that yield curve inversion makes clear that the rate hikes the market thought were coming are not.
Trump, who has been vocal in his criticisms of Powell and the Fed’s plans to raise rates, was apparently happy with Powell’s speech, according to comments from Treasury Secretary Steven Mnuchin. Other prominent figures have also been questioning the Fed’s stance, with a former Dallas Fed vice president calling it “very aggressive” earlier this year. Fed Vice Chairman Richard Clarida told CNBC last week the Fed is “much closer” to neutral.
The issue of the Federal Reserve’s interest rate increase policy is closely tied to the problem with the inverted yield curve. What role should the Federal Reserve play with regard to managing the economy? Does the Fed create business cycles, expansions and recessions by way of Federal Reserve policies (interest rates, open market activities)? Or is the Fed a reactive steward, using tools to manage the economy off the edge of other dangers?
The US may or may not have a recession next year, but the economy is expected to grow at a slower pace and the trade wars raise concerns that earnings growth could slow even more. November employment numbers were weak, but this is not alarming with unemployment at a historically low 3.79%. There are numerous reasons, political pressure notwithstanding, to give the Fed cause to reconsider their position on rate hikes.
Business cycles are natural, and the succession of expansions and contractions should not lead investors towards the exits. An investment perspective that spans a time period encompassing many business cycles leads to the highest probabilities of success.
Yield Curve, Recessions and Comparison with the ‘70’s
Over the years, I have come to look at the 1973-1974 period as one of the worst investment periods in history. There was double digit inflation, an international oil crisis, went off the gold standard, Vietnam War, and the impeachment of Richard Nixon. From the beginning of 1973 through Nixon’s resignation the next year, the S&P 500 lost about 50% of its value. There were three recessions during this period, followed by a long recession at the beginning of 1980.
The Fed Funds Rate (the interest rate that the Fed uses to manage the economy) reached a high of 20% in 1979 and 1980. This was the Fed’s attempt to curtail runaway double-digit inflation. That bout of inflation began in 1973 after Nixon weakened the dollar by disengaging it from the gold standard. Previously, the dollar was backed by gold; afterwards, the dollar floated freely against other currencies.
Inflation tripled from 3.9% to 9.6%. The fed doubled interest rates in 1973 from 5.75% to 11%. Inflation continued to remain in the double digits through all of 1974. The Fed kept raising rates to counter inflation, but inflation kept rising. Eventually Fed leaders learned that managing inflation expectations was a critical factor in controlling inflation itself.
In 1979 Fed Chair Paul Volcker ended the Fed’s spiraling policies. He raised rates then kept them steady finally ending inflation. That created the 1980 recession, but double-digit inflation hasn’t been a threat since. During that period of time, stock market returns varied widely from positive to negative.
What can be learned from the chart above? When the US went off the gold standard, the dollar had to begin floating against other worldwide currencies. Inflation ramped up to double digits. There was an oil crisis and later a constitutional crisis with Nixon’s impeachment.
1973 and 1974 were horrible back to back negative years for the stock market, as represented by the S&P 500. At the end of two years, an investor earned -20.08% per year; they were down over 40%. From peak to trough, the losses were even more. Nonetheless, the following two years of return were very positive and the investor more than broke even, slightly positive for the 4 years, 1.6%. By 1985, starting with 1973, the investor received an average annual return of 9.6% per year. Thereafter, through 2017, average annual returns exceed 10% every year except during the 2008-2009 period where the crash pushed the average annual returns down to the 9.8% territory.
From the two charts, the previous one showing the recessions, you can see that although the 1980 recession was prolonged (with a wide grey area showing in the chart) the impact on the stock market was minor, only on -4.9% year in 1981.
There is nothing to fear in stock market volatility for the patient, long-term investor.
Out of curiosity, in reviewing this 1973-94 period, I read the entire Wikipedia account of Watergate and the impeachment and ultimate resignation of President Nixon. It strikes me not without parallel to our current situation.
The entire process, from break-in, to discovery, to Congressional hearings, impeachment and resignation took only a little over two years. For a sitting president to lose a base of support to be forced out of office required the upheaval of public and official sentiments that eventually turned against him. Of the five Articles of Impeachment that were brought against Nixon, three passed and two failed. Article I passed with 6 Republican yes votes and 11 no. Article II passed with 7 Republican yes votes and 10 no. Article III passed with 2 Republican yes votes and15 no.
The backdrop of Nixon’s impeachment was also an economy that was truly failing and the increasing pressure against the war in Vietnam.
The situation is not, however, without parallels. What the investor can understand from this exploration is that the stock market continues to function through the upheavals of society. Although each situation is different, there is something to be learned from looking at the past.
Other Reasons for Market Volatility
While this issue is receiving a lot of attention in the press, I do not think that the trade wars are a more significant driver of the markets than interest rates and Fed policy. Over decades large US companies, particularly manufacturers have developed extensive global supply chains relying on worldwide sources of lower-cost production. Higher component costs due to tariffs could bring higher inflation over the long-term. But companies would eventually learn to maximize their returns under the new rules. The impact of tariffs is sector-specific, which is consistent with 45’s style of favoring a mechanism to reward friends and punishing enemies. He is, after all, a self-proclaimed ‘tariff man.’
Elevated Values for Stocks
Equities markets have been rising for 10 years, since the crash of 2008-09, where March 11, 2009 was the bottom. It is predictable for people to ask how much longer can this last? There are always increasing fears that the upward trend cannot continue. The recent pullback in the market has been led by tech companies often referred to as FANG: Facebook, Amazon, Apple, Netflix and Google. Many analysts consider these companies to be over-valued.
Global growth appears to be firm – for now. Although downturns are always disconcerting, occasional periods of turbulence are to be expected. It should be noted that despite the sell-off and the pick up in volatility, the backdrop for world equity markets remains generally favorable.
It is impossible to predict with certainty whether the sell-off will prove to be a temporary dip or something more serious. What’s more, timing the market is notoriously difficult. A failed attempt to time the market can hurt long-term investment performance in two different ways: first by selling assets when they have lost some value and going to cash, effectively locking in those losses, and second by missing out on at least some of the gains when the market bottoms and starts to rebound.
Sharp market declines can certainly be unnerving and cause anxiety, but we encourage investors to look beyond near-term volatility and stay focused on achieving their primary financial objectives (which are years and sometimes decades away). Markets are making waves amid a confluence of risks including higher interest rates and concern that tariffs and ongoing global trade disputes could ultimately put pressure on corporate profits. But let’s consider that this volatility is taking place against the backdrop of robust economic fundamentals in the US, and investors should remember that the long-term prospects for growth are bright. Near-term risks will always abound, but prudent long-term investors remain invested for the long run.
We continue to believe that a portfolio appropriately diversified across asset classes and aligned with an investor’s unique circumstances and goals remains a powerful way to accumulate wealth over the long term. It’s tempting to try to time the market during conditions like this, but this year should serve as an example that most attempts at timing will be fruitless. Small caps led the pack in Q1 and Q2 but reversed sharply in Q3. International developed markets did the opposite, reversing to the upside in Q3. Each investor knows best what is going to spur them to fight or flight but responding to those urges can often result in poor investment decisions over time.
Reversals cannot be predicted with accuracy. Practical investors should remain in a disciplined long-term approach with a level of risk and corresponding asset mix they are comfortable with in order to benefit from the potential of compounding of investment returns over time. Diversify appropriately, look past the near-term noise, and stay the course.