After months of low volatility and a sustained grind higher, stock markets experienced elevated levels of volatility the last two weeks. It seems the markets initially dropped because of fears of increasing inflation and interest rate. (An increase in interest rate is usually bad for stocks, all else being equal). Leveraged investment products and automated/machine trading probably further exacerbated the situation.
Stock market volatility is unpleasant but not new. In fact, as we often say, it is the price paid for receiving investment returns. Over the long term, the markets average one 14% drop per year. Even during bull markets such as the current one since 2009, markets have historically dropped by about 11% on average. Daily drops of 2% or more occur about 5 times a year on average. The last two years were very unusual- after falling by 15% in early 2016, the equity markets rallied higher for 404 days without a single 5% drop- this was the longest such stretch in market history. This was capped by an unusual, above average 6% rally in January after which, any whiff of bad news was likely to destabilize the market. The market has now fallen about 10% from the peak set in January, well within historical norm.
As we have been saying since early 2017, there is a synchronized global economic recovery underway which should support stock prices. We don’t see any evidence that the global economy is going into a recession anytime soon (Recessions cause markets to fall by a lot). Economic indicators in manufacturing, non-manufacturing, retail sales and employment, all point to a healthy global economy. Inflation is increasing but not high, and there is considerable demographic, technological and global headwinds to a sustained pickup in inflation. Interest rates will increase from current levels, but the Federal reserve continues to say it will increase gradually. Historically, during the early stages of interest rate increase, stocks continue to rally because the economy is still strong.
Stocks are expensive as compared to historical averages, especially in the US, but despite the recent increase, interest rates are still relatively low, which should support the valuation. Corporate profits are growing at a healthy clip and while stocks are below where they started the year, earnings estimates have increased since then (First quarter earnings estimate increased by a record 4.9% in January according to Factset) making stocks cheaper than they were at the beginning of the year. Stocks outside the US are cheaper and there are some compelling investment opportunities overseas.
As markets assess the impact of increasing inflation and interest rate, stock prices are likely to remain volatile. A well-diversified portfolio such as the ones we create at Sarsi, can weather market turbulence. Our portfolios have been positioned for resilience across multiple scenarios and are performing as expected. At times like this it is important to stay focused on the long-term drivers of performance and not make any hasty decision.
Please reach out to me if you would like to discuss this further or we can help you or someone you know.