Volatile Markets

News organizations like dramatic headlines, but they increase investor nervousness if not placed in proper context

While the 1,175-point decline on Monday is the largest point drop in the Dow, it is only the 99th largest decline in percentage terms (-4.6%). That’s not nearly as attention-grabbing, is it?

In total, the recent market decline has simply brought us back to early December 2017 levels.

We’ve had two years of steadily improving stock markets with very little volatility. In fact, we haven’t had a correction since the last one in the summer of 2015 through February 2016.

If we look at history, these periods of stability are most often followed by more dramatic market movements. Interestingly, recent history shows that spikes in volatility tend to lead to above-average returns for the subsequent two to three months.

Check out the charts below on the VIX, the CBOE Volatility Index.

So, what’s behind this recent market move?

Although we can point to several fundamental reasons for the market selloff, the ferocity of the move might best be explained by technical factors, including trading in the XIV (an instrument created to bet against volatility) and increased volume in passive trading.

Low levels of volatility had persisted for the past year, and a number of traders used XIV to bet that volatility would remain subdued. The calmer the markets, the more profitable the trade.

However, when volatility spiked in the last couple of sessions (for the fundamental reasons cited below), those traders tried to cut their losses, causing downward pressure on the U.S. stock market. As a result, Credit Suisse announced that the last day of trading for XIV would be February 20th. Good riddance.

Trading in passive funds was another contributing technical factor to the selloff. According to the National Bureau of Economic Research (NBER Working Paper No. 20071), “ETF ownership of stocks leads to higher volatility and turnover.”

As of 3:30 p.m. Monday, ETF trading equaled 40% of stock market volume, well above the typical 25%, and therefore exacerbated volatility.

Fundamental factors behind the market decline

There are also several fundamental drivers behind the recent downturn:

1. Rising Treasury yields

Treasury bond yields jumped last week due to concerns about inflation after a government report showed unexpected increases in U.S. wages.

Part of the recent rise in stock prices has been supported by very low interest rates. As rates rise, the present value of future corporate earnings declines, putting pressure on equity valuations.

2. Trade tensions

Ongoing concerns about trade tensions with China have added to market uncertainty.

3. Leverage unwinding

As markets declined, investors who borrowed money to buy stocks began reducing positions and lowering leverage, adding to selling pressure.

4. Stop-loss orders

Investors with stop-loss orders had them triggered, increasing the volume of automatic selling.

Just as “animal spirits” can lift markets, fear and forced selling can amplify declines. There is always a psychological component to market behavior.

So, what’s a prudent investor to do?

To benefit from the long-term performance of the stock market, we must understand and endure periods of volatility.

This is an excellent time to reassess your risk tolerance and ensure your portfolio allocation remains appropriate for your long-term goals.