Volatile Markets

News organizations like dramatic headlines, but they increase investor nervousness if not placed in a proper context. While the 1175 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 improvingstock markets with very little volatility. In fact, we haven’t had a correction since the last one in the summer of 2015 throughFebruary 2016. If we look at history,these periods of stability are most often followed by more dramatic marketmovements. Interestingly, recent history shows that spikes in volatility tend to lead to above average returns for thesubsequent 2 to 3 months. Check out the charts below on the VIX, the CBOEvolatility index.

So, what’s behind this recent market move? Although we can point to severalfundamental reasons for the market selloff, the ferociousness of the move mightbest be explained by technical factors including trading in the XIV (an instrument created to bet against volatility) and theincreased volume in passive trading.

Lowlevels of volatility have persisted for the last year, and a number of tradersused the XIV to bet that volatility would remain tame. The calmer the markets, the more profitable the trade.  However, when volatility spiked in the last coupleof sessions (for the fundamental reasons we cite below), those traders tried tocut their losses, causing downward pressure on the U.S. stock market. As aresult, on Tuesday, Credit Suisse announced that the last day of trading forthe XIV will be February 20th. Good riddance. 

Tradingin passive funds was another contributing technical factor to the marketselloff. According to the National Bureau of Economic Research (NBER WorkingPaper No. 20071) “ETF ownership of stocks leads to higher volatility and turnover.” As of3:30 PM Monday, ETF trading equaled 40% of stock market value, well above thetypical 25%, and therefore exacerbated Monday’s volatility.

On the fundamental side, there are a number ofpossible triggers for the market downturn.First, Treasury bond yields jumped lastweek due to concerns about inflation after a government report showedunexpected increases in U.S. wages. Part of the past increase in stockprices has been due to very low interest rates. Now that rates are rising, the expected value of future corporateearnings is reduced. Second, thereare concerns about trade tensions with China. Third, once the market went down, investors who borrowed money to buy stocksstarted selling some of their positions and reduced their borrowings.Lastly, investors with stop loss ordershad them executed, increasing the volume of sales. Just as 'animal spirits'lifted the market, anxiety and selling can feed on itself. There is always a psychologicalcomponent to the market. 

So, what's a prudent investor to do?  In order to benefit from the long-termperformance of the stock market, we have to understand and live through theseperiods of volatility. It's an excellent time to reassess your risktolerance and make sure your portfolio asset allocation is right for you.