Tuesday, April 10, 2018

The Return of Stock Market Volatility

John C. Watkins, CFA®
Author position
Equity Portfolio Manager - Hilliard Lyons Trust Company

The Return of Stock Market Volatility

The return of market volatility in the first quarter of 2018 was a stark reminder that the stock market doesn’t move steadily upward forever. While the S&P 500® finished the first quarter little changed from where it began, February and March were anything but smooth. After 15 consecutive months of positive returns and negligible volatility, the S&P 500 reversed course in February and fell -10.2% over only nine trading days. At its January 26 peak, the S&P 500 hit an all-time high of 2,873, up +7.5% year to date, and showed no signs of slowing. From there, it seesawed, falling -10.2% by February 8, rebounding +8.0% by March 9, falling another -7.1% by March 23, and then rising to 2,641 to close out the quarter down -0.8%. That’s its first quarterly loss since 2015.

What happened?

Short-term market swings are often difficult to explain fully, but here are some likely drivers behind the recent volatility:

  • Average hourly U.S. wages grew +2.9% year over year in January – the fastest growth since 2009 – stoking fears of higher inflation.
  • Interest rates on 10-year Treasury notes rose from 2.41% at the start of the year to a high of 2.94% in late February and ended the quarter at 2.77%. Though these rates are still low in absolute terms, rising rates can act as a headwind to economic growth. 
  • The new Federal Reserve Chairman, Jerome Powell, took over in February, introducing further uncertainty into future interest rate policy. 
  • Finally, President Trump’s announced tariffs on steel and aluminum ignited fears of a broader global trade war that some fear could derail synchronized global economic growth. 

The Standard & Poor’s 500 is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.
The Standard & Poor’s 500 is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.

The storm after the calm 

The abrupt change in the broader stock market environment is noteworthy because it ended a period of abnormally low volatility and seemingly “easy” equity returns. The lack of market volatility before this quarter was remarkable. The February market correction ended a streak of 404 trading days without a 5% drop – the longest streak on record and more than four times longer than the average of 92 days. Furthermore, the last time the S&P 500 fell more than 10% was two years ago, in January of 2016.

So what is “normal” volatility, anyway?

After an extended period of low volatility and increasing equity prices, it is easy to forget that stock market volatility is normal. Two years without a meaningful correction lulled investors into thinking the markets are smooth, yet history tells us that is not the case. Since 1950, the average intra-year decline was 13.5%, and there were double-digit declines in more than half of the years. Between the market low in 2009 and the latest correction, the S&P 500 had four separate double digit declines: -16% in summer 2010, -19% in August-October 2011, -12% in August 2015, and -13% in January/February 2016. With the largest decline in 2017 coming in at -3%, it is clear that 2017 was the truly abnormal year, and the current market environment may simply be a return to normalcy.

Will this volatility continue?

Regular readers of this newsletter know that we typically avoid making predictions. It is impossible to accurately and consistently predict the future, especially with regards to the direction of short-term market prices. That said, we do have one prediction we are comfortable making – stock prices will continue to both rise AND fall in future years. Eventually, there will be another bear market and another recession. Unfortunately, nobody can consistently predict the timing of these events, but they are inevitable. Setting these expectations is important for equity investors because short-term drawdowns are a regular occurrence, even as markets produce attractive long-term returns. Mental preparation for volatility reduces the chances of emotional decision-making, which can impair long-term returns.

How are we responding?

The recent increase in market volatility has no impact on how we manage your assets. The bedrock of our investment philosophy is adopting the mindset of a long- term owner of a private business when investing in equities. As long-term business owners, we focus on the underlying intrinsic value of each business that we own based on the economic prospects of that business, rather than on the short-term fluctuations in its share price. If the business becomes more profitable over time, its stock price will eventually follow, regardless of short-term changes in perceived value.

The “father of value investing,” Ben Graham, was quoted as saying, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” Said another way: over shorter time periods – days, weeks, months, even a year – the market behaves like a popularity contest. Stock prices fluctuate based on investor perception and emotion, while the underlying values of businesses are much more stable. Over periods of 5, 10, and 20 years, these short-term price swings are simply noise, and the underlying economics of the business will be accurately reflected in its stock price.

In his 1949 book, The Intelligent Investor, Graham proposed a mental attitude toward market fluctuations that we ascribe to: He said to imagine you are partners in a private business with a gentleman named Mr. Market. Every morning, Mr. Market comes into your office and quotes a price where he will sell you his stake or he will buy yours. Mr. Market is extremely emotional and offers highly variable prices even though your business has stable economic characteristics. Some days he is optimistic about the business prospects and quotes a high price, while other days he is pessimistic and quotes an inexpensive price. Importantly, you can simply ignore Mr. Market and he will return the next day with a new price. As Warren Buffett wrote in his 1987 letter to shareholders: “Under these conditions, the more manic-depressive his behavior, the better for you. But … you must heed one warning … Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.”

We follow Graham’s and Buffett’s advice by constantly monitoring market prices but never letting them guide us. Short-term stock price movements tell us nothing about a business’s fundamentals. Instead, we do everything we can to ignore short-term emotional fluctuations and focus on analyzing a company’s economic characteristics. We act only when the market price deviates meaningfully from our estimate of a business’s intrinsic value. The rest of the time, we ignore Mr. Market and wait to see what his next quote will be. We always strive to avoid emotion, think rationally, and take advantage of infrequent opportunities to purchase great businesses at reasonable prices.

Volatility ≠ Risk

Contrary to widespread academic theory, we do not view volatility as risk. Volatility is simply fluctuations of a company’s share price, both up and down. In fact, as detailed above, we view volatility as a potential opportunity to purchase an outstanding business franchise at a discounted price. In our opinion, true risk is failing to achieve your investment objectives over the long term. Our ultimate goal is to help you achieve your investment objectives throughout all market climates over long periods. One important strategy we use to achieve this goal is to own a concentrated portfolio of companies with sustainable competitive advantages, talented and honest management teams, and compelling prices while patiently allowing the business value to compound over decades.
Even though the stock market is more volatile this year, it is difficult to find any glaring weaknesses in the broader U.S. economy. GDP growth is accelerating, unemployment is near all-time lows, consumer confidence is at all-time highs, capital investment is increasing, and government expenditures are rising. Interest rates and inflation are both beginning to trend higher, but they remain at very low absolute levels, with room to increase before becoming a substantial economic headwind. Additionally, corporate earnings will see a significant boost in 2018 due to tax reform, and global economic growth is accelerating.

Our steady long-term perspective 

This strong economic backdrop does not change the fact that markets are volatile. Prices will continue to rise and fall based on short-term investor emotions. Some weeks, months, and years will be more volatile than others. In the face of this uncertainty, we will stay disciplined in the investment philosophy that has guided us over the past several decades. Our sole focus is on investing your assets in only high-quality stocks and bonds as we help you achieve your investment goals in the years to come.


Past performance is not a predictor of future success. All investing involves the risk of loss.