April 26, 2018
Dow Jones Average: 24,084
S&P 500 Index: 2,639
The Return of Volatility
After a lengthy period of muted moves in stock prices, daily price volatility has returned to the market in a big way this year. From early 2017 through January 2018 there was not a single day where the S&P 500 Index rose or fell by 2% intraday. Given the geopolitical backdrop in 2017, the relative calm in stocks was remarkable. Things have certainly changed in the past few months. Since February 2018, there have been sixteen days of wild daily gyrations of 2% or more. The downswings have been stronger than the rallies, leading to the first market correction of 10% in two years.
We could point to a number of factors that precipitated both the market decline and upswing in volatility. The growing prospect of trade wars seems the most likely culprit. In the past, Donald Trump has described himself proudly as an unpredictable iconoclast. Markets finally took notice recently when the President issued a handful of rogue tweets about the benefits of trade wars and the ease at which they are won, spooking most investors and economists. Truthfully though, each bout of market volatility has had a slightly different root cause, if one can be identified at all. The simplest explanation is that the underlying psychology of this market is changing. While investor sentiment was buoyed last year by the prospect of tax cuts, it now seems to be undermined by rising interest rates, trade tensions, and political uncertainty.
The rise in volatility is the most significant development so far of 2018, and it has been challenging for investors. The gyrations have made it all but impossible to predict near-term direction or predict how stocks will respond to news. The volatility has been directionally downward, meaning that most of the time stocks are drifting lower, even as they whipsaw back and forth. There is no single theme or sector that has escaped the decline, reflecting a modest sell off that has been quite uniform in nature. Safe havens, like utilities and consumer staples, have fallen just as fast as the rest of the market. However, in contemplating longer investment time frames, there is an important message for investors and one, like so many others, we borrow from Warren Buffett.
The message is this: a more volatile market is not necessarily a riskier market. A long-term investor should view risk and volatility as two distinct concepts. We define risk as the likelihood of long-term loss of capital, and we do our best to avoid risky investment scenarios. Technology companies were a risky choice in the spring of 2000, as were financial stocks in 2007-2008, leaving many buyers with deep and permanent losses. Volatility, on the other hand, simply measures short-term swings in the prices of investments. These swings do need to be managed intelligently within a portfolio, but the long-term goal remains minimizing risk, rather than volatility. History has shown us repeatedly that it is often those moments when stock investors are most sanguine, and allow valuations to climb excessively, that stocks become risky long-term investments. The long-term rewards actually improve for investors as stock prices decline in a period of increased volatility and investor angst.
Amidst this volatility, companies actually had reasonably good news to offer investors. Revenues are growing at a faster pace than in recent years and some of the benefits of the corporate tax cut are accruing to companies in the form of increased profitability. It is important to note that all of this good news comes years into an economic recovery and bull market. It is certainly possible that investors are newly fearful that these may be the last threads of good news. Just this week Caterpillar reported fantastic results, but also indicated that that may represent a high-water mark for them. This kind of message fuels the idea that we may be approaching the end of easy growth for many companies.
While volatility was the major topic of conversation in investment circles this quarter, it did not create enough movement in prices to substantially alter our allocation to stocks. The upswing in prices during January did not take prices to unrealistic, euphoric levels that would engender a lot of selling on our part. And the subsequent correction in stock prices did not take prices to a meaningful buy point in our opinion. We did trim back on a few big gainers when prices rose in January, and replaced them with a couple of new investments through February and March. Our actions were limited in scale and the change in asset allocation for most clients was marginal. We continue to maintain a slightly defensive posture in terms of stock ownership for most clients.
It has also been a rough quarter for bond investors, especially those with longer-dated maturities. Investors tend not to expect losses in their bond portfolio, but this year yields have risen sharply and bond prices have fallen. The bulk of our bond portfolio in client accounts is extremely short-term in nature and has not experienced similar declines. We are instead encouraged by the decline in price of these longer-dated bonds, as it affords clients the possibility of higher yields on fixed income in the future.