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What’s Causing the Spike in Market Volatility?

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RANDY FREDERICK: After more than a year with no meaningful pullbacks and an unprecedented period of low volatility, the long-overdue market correction has finally arrived. Liz Ann Sonders joins me for the February 6th Schwab Market Snapshot to talk about what happened and why.

So Liz Ann, 2017 was a historic year for a number of reasons, not just because of the low volatility, but also because the biggest downturn we had all year was less than 3%. Unfortunately, we’ve made up for that and then some in just the past week. So the question is what signs were out there that this big volatility spike and market correction was coming?

LIZ ANN SONDERS: So, Randy, as you know, we were a bit more cautious starting last year, and some of it was purely a function which of what you already touched on, which is the lack of volatility in a year like last year. It was a strong year for the market, all-time highs for the market. The maximum drawdown, one way to measure volatility, was the second-lowest in history. Only 1995 was better than that.

And if you look at the history of years where you had a very, very minimal drawdown and look at the subsequent year, almost every case, they were years with more volatility—a greater frequency of pullbacks and spikes in volatility, and a larger maximum drawdown. So that was a factor. And then I think because of how calm markets have been and the strength preceding this recent downturn, optimism really, really accelerated and many measures of investor enthusiasm had gotten to record levels. So those were two warning signs.

Now, I want to pose it back to you, though, and I think one of the tough things about this environment is some of the hyperbole—you know—a lot of headlines around the largest Dow decline in history in point terms. Let’s keep in mind that it barely makes in the top 100 in percentage terms, and I think it’s 138th in S&P percentage terms. That said, it is still painful when you’re in the midst of it. So I know what a lot of investors want to know, and this is your bailiwick, is is this likely to continue in the near-term or have we exhausted most of the selling?

RANDY: Yeah, and I think looking at the points makes the bigger headline than looking at the percentages. But I think the important thing is that, clearly, the bulk of this downturn was driven by technicals and not by fundamentals. And I think, you know, it’s probably a little bit too early to wave the all-clear flag just yet.

We’ve had a couple of times throughout the last few days where it looked like things were settling down and only to go into another wave down, so I’m a little bit cautious to say we’re not sure this is over just yet. I do think in the long-term this will end up being a pretty good buying opportunity, but we’re just not sure that that’s there just yet.

Unfortunately, as unsettling as these things are, in order to keep a long-term bull market going, we have to have a few corrections along the way in order take out some of speculation. But patience is of the utmost importance during these times. Two things that I always warn traders to stay away from, and one is don’t panic sell when things are selling off very sharply because that never works out well. And, secondly, avoid the temptation to bottom-fish because catching the bottom is extremely difficult, and it’s always a lot less stressful to miss the bottom on the way back up than to miss it while it’s still going down.

So, Liz Ann, let’s assume that you and I kind of agree that there might be more volatility or more downturn to come. I think the question on every investor’s mind, then, is does this potential pullback—does this pullback have the potential to meltdown even further into a full-blown bear market decline of 20% or more?

LIZ ANN: Well, first of all, I completely agree with what you say, and as I often say, panic is not an investing strategy. Now, whether the near-term, the technical problems, as you pointed to the spike in volatility, which caused a lot of forced selling of these instruments—many of these instruments that are tied to low volatility—I’m not sure how much longer that will take.

But it’s been our view that the next true bear market will likely be a more traditional bear market, and it will be a function of the market sniffing out the next recession. Now, I think that’s still a ways away and that’s because growth is actually improving, it’s strong. That’s part of the reason for some of the issues with inflation and tighter monetary policy. But I do think we have a decent length of runway between now and the next recession.

RANDY: Yeah, and what I think you mean by that is that we need to see a deterioration in the fundamentals, too, which we just don’t have yet. Liz Ann, thank you so much for joining me.

Listen, you can read more from Liz Ann in the Insights & Ideas section on Schwab.com. You can follow Liz Ann on Twitter @LizAnnSonders and, of course, you can always follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.

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Definitions

The Dow Jones Industrial Average (DJIA) includes the stocks of 30 of the largest and most influential companies in United States.

The S&P 500® Index is a capitalization-weighted index of 500 stocks from a broad range of industries. The component stocks are weighted according to the total market value of their

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