In our report on 2017 we highlighted the almost complete absence of volatility (‘vol’) in major markets.
Well, last night the US market dropped around 1,200 points on the day and a little over 700 in 11 minutes (about 3%). So ‘vol’ is back and honestly, it’s about time and a good thing in the main.
What’s caused it to happen now?
As always with finance and economics there are lots of people with lots of theories, but we suspect that fundamentally the main issues are.
- Now the Tax Bill has been signed there is no imminent ‘next good thing’ to happen in the US for markets to anticipate. Yes, Company earnings and profits are going up a lot this year and in 2019, which was the reason the market flew out of the gate in January but that’s known.
- What is not known (and what has just started to happen) is what to make of the facts that Treasury yields (US Government debt) started rising and the last jobs report showed accelerating wage inflation. You’ve now got interest rates and inflation starting to push higher, neither of which had shown any signs of life in 2017.
- As volatility had been so subdued for so long quite a number of larger investors have been selling volatility contracts to make extra returns. (Think selling insurance on the chances of volatility spiking, which then hadn’t been claimed on as it didn’t, so they kept the premiums as profit.) Hey hey we’re so clever!! This had become the trade ‘du jour’ and as with all such good ideas, they work until they suddenly don’t, and then you get everyone rushing for the exit at the same time which causes additional price volatility (and losses for the clever fellows above).
- The short-term effects on markets of ETF and mechanical/computer-controlled investing are particularly significant. Firstly, you have purely computer model driven funds which are programmed to sell at given levels of declines, which cause more declines, leading to more programmed selling. You’ve then got the investment accounts with stop losses on them, which means investors put a floor price on a share and if it goes below is automatically sold, which causes prices to go lower and triggers more stop loss selling. You’ve then got the ETF investments which when they have down days need to sell stocks to raise capital, this is mostly an index like the S&P 500, so they sell stocks in every company in the index so putting downward pressure on markets in general and people see this, act emotionally and sell etc etc.
Conclusion
Absolutely nothing has really changed from a week ago when all investment skies were blue, and things were peachy and creamy.
- The World’s major economies are growing strongly.
- Interest rates are super low and yes, going up, but not aggressively. The various central banks will give very long-term notice to markets of their intentions, so no surprises.
- The US tax cut effectively makes the stock market around the same value as it was at the beginning of 2017, because the increase in profits of a lower rate will be about the same in 2018 as the market increased by in 17.
- A strong world economy can cope perfectly well with higher rates and from a longer term economic perspective it’s important for them to be higher, so they can be lowered the next time the economy needs stimulus (at the start of the next recession).
- Wage inflation is good if not too aggressive, as it gives people greater disposable incomes to spend and importantly it stops or at least reduces the wide spread sense amongst the many (whose incomes have atrophied) that the few are taking unfair advantage.
Finally, and probably most importantly the occasional sharp correction keeps investors honest, stops complacency and reinforces the need for discipline and emotional balance.
As we have often previously noted, most proper crashes come after long periods of calm where investors have become complacent and excesses have been rewarded.
So welcome back ‘vol’, you were missed.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.