RANDY FREDERICK: 2017 was the least volatile year for equities in 25 years, but that all changed in February of this year, and now volatility gauges like the VIX are running about double last year’s levels. In this week’s stock market report, I’d like to talk a little bit about why volatility is so elevated and what you can do about it.
Volatility by definition is a non-directional measure of movement. In the marketplace, however, volatility and risk are typically synonymous, and historically we know that gauges like the VIX actually move opposite the market about 80% of the time.
Now the current levels of volatility have emanated from a number of different sources: political uncertainty, concerns about rising inflation, concerns about rising interest rates, concerns about a trade war, cybersecurity fears--all of these different things. Now generally, when the market transitions from a period of low volatility (like we saw last year) to a period of high volatility (like we saw this year), initially volumes tend to spike. Trade volumes tend to go up a lot, and the reason for that is that sometimes investors are taking profits, sometimes they’re putting on hedges, sometimes they’re actually bargain-hunting, trying to buy when stocks dip. But when that volatility persists for a very long time, eventually those trade volumes start to drop off, and people essentially sit out.
Now you might ask yourself: Well, why does this really matter? And the reason it matters is because, on a very basic level, what makes the market go up is actually new money coming into the market. But when volatility persists for a very long time, especially when it’s very driven by news, eventually people will start to sit out of the market, and when that happens then there’s no new money coming into the market, and eventually trade volumes start to fall off. The problem is when trade volumes start to fall off, the market starts to go down, and if the market goes down, that can spark more volatility, which can start more downturns in the market, and so on.
During periods of high volatility some investors might be tempted to take a look at products that are directly or indirectly tied to volatility. These products aren’t a good idea for most investors because they’re very complex, and oftentimes they don’t move the way people expect them to. Other investors might be tempted to sell some of their holdings and increase their cash allocation. While small changes might be a good idea, very large changes are probably not, and the reason for that is because that will eliminate your opportunity to participate in further upside in the market. In 2018 we actually think that’s very likely. Part of the reason for that is that the economic data is still very strong. The unemployment rates are very low, so the labor market is strong. Interest rates, while they’ve risen a little bit, are still fairly low on a historical basis. The manufacturing sector and services sector are doing quite well, sentiment is actually quite strong, and, in fact, we are right now moving into Q1 earnings season, and with the tax cuts that were enacted at the end of last year, corporations are expected to increase their earnings by 17%.
The best approach when volatility gets high is to not panic; don’t be tempted to buy on the dips, because finding the bottom is very difficult. Don’t panic-sell when things get a little bit rocky; take a look at your long-term asset allocation and make small changes if necessary, but primarily: Don’t panic and keep focused on the long-term.
You can read more about our thoughts on the markets and the economy in the Insights & Ideas section on Schwab.com. And don’t forget, you can always follow me on Twitter @RandyAFrederick.
We’ll be back again. Until next time, invest wisely, own your tomorrow.