Andrew Adams, CFA, CMT, Senior Research Associate, reflects on 2017 and the return to normality that February’s market pull-back represents.
While equity investors extended a warm welcome to the quiet ascent of stock prices last year, at some point, the party had to end. ‘Guaranteed’ is not a word typically used in the investment business, but the expectation for more volatility in 2018 compared to the prior year was about as close to a guarantee as the stock market can offer.
By some measures, 2017 was the least volatile year for stocks in the history of the market. Investors became accustomed to the calm and quiet fluctuations of the market. However, a continuation of this record-breaking run for another 12 months was too much to ask for.
So how tame was 2017? Well, it was the only calendar year on record in which the S&P 500 had a positive total return every single month. The index also never even dropped 3% from a previous closing high, which is quite unbelievable compared to the 16% average intra-year drawdown over the last 100 years. Moreover, only eight total sessions closed up or down at least 1%, and the S&P 500 never had a 2% up or down day.
One could even say that the stock market was downright boring at times in 2017, though most investors did not seem to mind the slow and steady ascent to a number of new all-time highs during this extraordinary run. Through March 16 of this year, by comparison, the index had already experienced 17 up or down sessions of 1% or greater, including separate 2%, 3%, and 4% down days!
Inflation, Interest Rates, and Reversion to the Mean
Alas, all good things must come to an end and, in early February, volatility came roaring back to quickly knock many world indices into 10% correction territory. As is usually the case during and after such declines, market participants and pundits rushed to assign a specific reason for the sell-off, and concern over inflation and higher interest rates were the most often cited explanations. Such worries likely contributed to triggering the initial drop. However, the decline can also be viewed simply as a reversion to the mean that took place at a time when the U.S. stock market was as extended to the upside as it ever gets.
Leverage and Index-based Strategies
Additionally, traders built strategies to take advantage of the low volatility we enjoyed for so long, often using leverage to do so. Many of these strategies began to unwind once volatility picked up, creating a vicious cycle of selling in the market. Tack on the indiscriminate sales of index-based investments that hold baskets of stocks representing entire indices, sectors, and themes, and it becomes easy to see how things quickly spiraled out of control. Instead of one cause, a combination of factors likely compounded and contributed to the decline.
More important than what caused the correction is what did not cause it. It was not a situation where the market saw a deterioration in either the global synchronized economic expansion or in the strong corporate earnings data that has supported this secular bull market over the last few years.
We believe the February correction was more of a trading event, not the kind of recessionary or systemic breakdown that has generally caused more significant declines in market history. In fact, what happened in early February was not abnormal; the preceding 15 months of persistent upside were abnormal. Since 1932, the S&P 500 experienced on average a 10% correction about every two years, and it had been almost exactly two years since the index’s last such correction back in February 2016. Right on schedule.
Now the question becomes whether we should expect more volatility to occur throughout the rest of 2018. It would, of course, be great if stocks returned to their straight climb with very little downside. However, to reiterate, movement like that has historically been much more of an exception than the rule. The odds favor further bouts of the ‘episodic volatility’ that can arise whenever the market begins to worry about something, though we continue to believe these should be viewed as opportunities within an ongoing secular bull market rather than a reason for significant concern. We still do not see the signs that have preceded the major bear markets in history and, until we do, we will continue to give the benefit of the doubt to the bulls.
Our modern markets may also be producing more of the sharp swings that we’ve seen at times over the last few years. With high-frequency trading algorithms moving in and out of positions before many human traders can even open up their trading applications, it is not too much of a stretch to assume stocks will move a bit faster. More money flowing into passive investments and basket-trading strategies could also be contributing to the volatility, though it is difficult to isolate and estimate their exact impacts.
In prior decades, active investors accounted for a greater share of total trading volume and traded based on fundamentals and valuations. When stocks within indices like the Dow Jones Industrial Average were sold, we could count on other stocks within the indices to be bought, limiting the net impact on the indices themselves. Now, with more money than ever flowing to index-based products, sharp swings are more likely to happen as investors are able to effectively buy or sell shares of the entire index at the same time.
The good news is that these spells of volatility should not require altering the investment plan for most long-term investors. By expecting price swings, and perhaps even viewing them as an opportunity to buy at lower prices, one will be less likely to panic and sell out of long-held positions at what could be very inopportune times. And remember, just last year the Dow Jones Industrial Average hit a new record high 71 times, which was a new annual record in itself. That means despite all the previous bouts of market volatility in history, stocks have generally prevailed. Going forward, we don’t believe that is likely to end, despite the occasional rough patch.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates, Inc. and are subject to change. Investing involves risk including the possible loss of capital. Past performance may not be indicative of future results. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. The Dow Jones Industrial Average is an unmanaged index of 30 widely held securities. The S&P 500 is an unmanaged index of 500 widely held stocks. It is not possible to invest directly in an index.