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The inevitable return of stock market volatility: How can investors manage the bumpy ride?

Have you ever been on a roller coaster, or whitewater rafting or suffered through turbulence while flying? The feeling of a loss of control is palpable as you rock, sway and anxiously await the end of the turmoil. That’s what market volatility feels like — a fear-inducing process that leaves you wishing you had opted for a safer, more secure path. A recent increase in volatility in the financial markets has been scary given how calm the markets have been for the past several years. A 50% drop in oil prices, followed by another debt implosion in Greece, the collapse of the Chinese stock market and a complete breakdown in commodity prices have left many investors shaking their heads and wondering where to turn with their hard-earned money. Is historical volatility destined to return? If so, how should long-term investors manage the new environment?

First, let’s define volatility. The term is often used to describe the degree of fluctuation in market prices for publicly traded financial instruments, such as stocks or bonds. While it is generally associated with a falling market, volatility can also occur within a rising market. For example, there was a lot of price fluctuation in 2008, as stocks were crashing, but there were also significant price swings from 2009 to 2011, as the market was in a general uptrend. While we have seen some commodity and bond market volatility over the past year, we have not experienced any real degree of prolonged stock market volatility for over three years (Figure 1.0). But that is likely to change.

Figure 1.0

Since the end of the Financial Crisis in 2009, investors have been comforted by the safety net provided by the Federal Reserve, i.e. a near zero Fed Funds rate and quantitative easing (QE). These preventative measures kept economic slowdowns from turning into recessions, and minor corrections from becoming major sell-offs. As a result, equity market declines have generally been moderate and followed by quick and powerful rallies, as investors have poured money back into the market on the belief that they’d be rewarded. This strategy worked well as the S&P 500 Index® has gained over 200% since 2009 (Figure 1.1), and we haven’t had a 10% or greater correction in over three years (which is the third longest period in history without one). However, this “buy the dips” strategy may need to be reexamined, as the Federal Reserve has ended QE and is expected to embark on an interest rate tightening cycle as early as September. So what happens then? Our guess is that we experience persistently higher, i.e., more normalized, equity market volatility for the next few years.

Figure 1.1

So does that mean it’s time to head for the hills and sock your cash under the mattress? Absolutely not. Now, it is possible (some say probable) that the stock market will experience a correction in the near term. In fact, the S&P 500 Index® is currently exhibiting a lack of healthy breadth, meaning that year-to-date gains are concentrated in a small handful of large companies while the average stock in the Index has performed poorly. The silver lining to this trend is that a reasonable (e.g., 5%–10%) equity market correction may actually be healthy following the strong market gains of the past few years, because it removes the uncertainty of when the “expected” decline will occur and should provide a boost to investor sentiment once the dust settles. Also, note that volatility can be an active equity manager’s best friend. Specifically, higher levels of volatility create more dispersion and lower correlations among stock prices, which give good stock pickers a better chance to identify companies that are undervalued.

Importantly, none of the traditional signs of an equity market top or an impending bear market are currently in place. Bear markets are the result of an economic recession, while market tops have historically been associated with excessive bullishness, widening credit spreads and rising real interest rates, none of which are present today or likely in the near term. In any event, stock market corrections are extremely difficult to time and should not be the basis for asset allocation decisions.

Stocks

Economic growth, particularly in the U.S., is showing signs of healthy expansion, while continued aggressive monetary easing in central banks around the world should produce continued demand for risk assets, like stocks. The rising U.S. dollar and falling oil prices (Figure 1.2) are a big boost for consumer spending, while the dramatic improvement in the U.S. employment market signals a faster growth economy on the horizon. Furthermore, U.S. stocks may feel expensive following the 200%+ gain in the market, but they are actually trading at valuation levels that are in line with 20-year averages. As a result, despite the expected onset of Federal Reserve rate hikes and likely higher volatility, we still find the long-term risk/reward potential in developed market equities, especially the U.S., to be attractive relative to other asset classes.

Figure 1.2

No doubt, there are many risks facing investors today. Interest rates that rise faster than expected, a surprise deterioration in corporate earnings growth, or a major economic decline in China could all create a greater downturn for stocks than we expect. And, the seemingly ever-present potential for a geopolitical event emanating from Iran, Russia or ISIS also presents risk for the stock market bull. However, history has shown that a well-diversified, actively managed portfolio and a long-term investment approach is the best way to manage any downturns associated with developments such as these. Also, many believe that once the Federal Reserve actually begins the rate hike cycle by raising the Fed Funds rate above the near zero bound it’s held for more than six years, the markets will rally simply due to the removal of the uncertainty surrounding the timing of the Federal Reserve’s first rate hike.

Bonds

Given the potential for somewhat higher short- and long-term interest rates, as well as the historically high absolute and relative valuation levels, we believe caution is warranted in the bond market. Rising interest rates have historically favored stocks over bonds, and we expect that relationship to continue. However, just as in the stock market, active managers can benefit from volatility in bonds and produce better than index returns. As a result, now is not the time to liquidate your bond portfolio, especially since the pressure on rates is likely to be slow and measured, but it is prudent to be prepared for greater uncertainty in the bond market.

Commodities

Commodities are a tougher call. Given the drastic decline in oil, copper, gold and other commodities, many believe the asset class is cheap and due for a rebound. But, the landscape is very uncertain right now, and the outlook is as murky as it’s been in years. Specifically, the economic slowdown in China and other emerging markets has reduced demand for many commodities (see relationship between China GDP and copper prices Figure 1.3), while increased production, especially shale oil in the U.S., has created excess supply at exactly the wrong time. Therefore, the prevailing fear is that it may be a few years before supply and demand come back into balance, and we can’t predict the oil/copper/gold price at which that occurs, so it’s more difficult to make a strong investment case for commodities today.

Figure 1.3

China Real GDP Growth

I don’t like roller coasters either, but as my son (who loves roller coasters) tells me, some things are inevitable. So, as volatility rises, the best course of action is to ensure you invest with active managers who possess a strong track record, stay focused on the long term, and remain well diversified. Then, when the ride ends, you can calmly walk off and go grab that funnel cake that you’ve been dreaming about.


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This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. The information contained in this presentation is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations. It does not take into account the particular investment objectives, restrictions, tax and financial situation or other needs of any specific client. This presentation makes no implied or express recommendations concerning the manner in which any client’s account should or would be handled, as appropriate investment strategies depend upon the client’s investment objectives. This presentation is for general information purposes only. This information does not represent any GuideStone product.