Kristin Byrnes, Product Strategy Analyst, Wealth, Retirement & Portfolio Solutions and Peter Greenberger, CFA, CFP®, Director, Mutual Fund Research & 529 Plan Product Management share their thoughts on a prolonged lack of volatility and its effects on the market.
The equity markets are the quietest they’ve been in nearly half a century, prompting industry pundits and investors alike to question why this might be and what it means for the markets going forward. By “quiet,” we are referring to a lack of volatility, namely the degree to which markets fluctuate (either up or down) on a daily basis. Generally, more volatile stocks and market indices are perceived to be riskier.
While volatility levels are by no means ‘normal’ from a historical standpoint, it doesn’t necessarily mean they are unwarranted or unprecedented. Keep in mind that volatility doesn’t drive the markets; rather, it is merely a byproduct of the market’s actions. Understanding the current environment helps to explain this state of complacency.
Inflows to passive investments have been on the rise for years now, as longer-term investors seek out lower-cost, tax-efficient, and diversified investment strategies. Index-based strategies allocate assets in proportion to the index, irrespective of individual security analysis. Additionally, increased automated trading by computers and algorithms has reduced the volume of trades marred by human error and emotion, thus decreasing the impact of these traditional (and sometimes irrational) forces behind market fluctuations.
Another school of thought claims that the growth of passive investing has reduced the volume of trades by ‘stock-pickers’ driven by fundamental analysis, contributing to increased correlations between securities across the board. However, given that intra-stock correlations are now at their lowest levels since the Great Recession, this theory may warrant additional scrutiny.
It should come as no surprise that technology stocks have been one of the key drivers of recent U.S. market performance – earning over 27% so far this year.1 Amongst other areas of the market, investors are treating price declines in this sector as investing opportunities, buying the dips before any negative impact is felt. While it has been most pronounced in the technology space, the willingness of investors to put cash to work during minor drawdowns in the market has helped stabilize and limit some downside that the market would otherwise have experienced.
Despite the fear that markets are overvalued and a pullback or correction is inevitable, we can’t ignore the general health of the equity markets. Healthy earnings growth, positive economic growth, and an extended period of low interest rates have fueled the uptrend in prices for quite some time. Positive earnings estimates going forward are also supportive of further appreciation.
While equity prices certainly are not cheap at the moment, the markets seem to have experienced some structural changes that should be considered when assessing valuations. For instance, companies in the U.S. large-cap space with higher margins, more growth opportunities, and a shift from tangible to intangible assets are gaining more and more market share. This begs the question: to what degree are they overvalued? Additionally, is history the most appropriate basis to make this call given these changes?
Following the financial crisis of 2008, central banks around the world have been passing out healthy doses of quantitative easing (which injects cash into the system), producing an accommodative, low interest-rate environment flush with cash. Where has much of that cash gone? To the global equity markets, which has resulted in its best performance run since 1998 according to the MSCI All Country World Index.
It’s not just financial market volatility experiencing these summer doldrums; global economic volatility has been low as well. Key drivers in the United States include reduced volatility in the job market, smoother corporate profits, and smoother government spending, which has historically been choppy.
Increasing market share of the service sector has contributed to the longer-term trend of quieter economic growth, which has traditionally been one of the less volatile sectors. Additionally, manufacturing is experiencing more consistent growth as advancements in technology continue to improve inventory controls.
Some market experts do not see this extended period of complacency as the ‘new norm’ and warn that investors are not accurately accounting for tail risks, or ‘black swan’ events. While there are valid reasons which support the lack of activity, volatility is likely to return at some point. Whether due to tightening central bank policy or a major geopolitical shock, volatility tends to spike following an unforeseen event, leading to significantly more bearish market responses as opposed to a more controlled increase in activity.
The direction and timing of the markets are anyone’s guess, particularly when it relates to unanticipated shocks. Since it seems likely that we just won’t know until we know, it’s important to manage your investments to the appropriate risk profile to ensure that proper safeguards are in place to protect your assets if and when the equity markets unexpectedly turn.
1 Performance as of 9/30/2017.
The chart is not indicative of any individual security's performance. The S&P 500® Information Technology Index comprises those companies included in the S&P 500 that are classified as members of the GICS® information technology sector. The index is unmanaged and cannot be invested in directly. The companies engaged in the technology industry are subject to fierce competition and their products and services may be subject to rapid obsolescence. Past performance may not be indicative of future results. There is no assurance these trends will continue. The market value of securities fluctuates and you may incur a profit or a loss. This analysis does not include transaction costs which would reduce an investor's return.
Diversification does not guarantee a profit nor protect against a loss. The companies engaged in the technology industry are subject to fierce competition and their products and services may be subject to rapid obsolescence. The returns mentioned do not include fees and charges which would reduce an investor's returns. Past performance may not be indicative of future results. Investing involves risk including the possible loss of capital.