Volatility spike: Investors have only themselves to blame
Perhaps controversially, we view the intellectual horsepower being consumed by the legions of writers commenting on every second’s movement in markets over the last few days not dissimilar to the wasted electricity consumed to validate speculative bitcoin transactions. Both activities are in our view of relatively modest economic value, even if there is currently heightened demand. There have been, in a historical context, only modest declines from the highs for major stock markets, albeit concentrated in the stronger local currency year to date performers of the US and Japan. In volatile times, investors must remain focused on the long-term outlook.
Volatility is where the action has been. Various “short” ETF volatility products which can be distributed to retail investors have lost almost all their value overnight as market volatility has spiked up to 25% annualised from record low levels. Counterparties may be hedged but US legal claims cannot be excluded. We had expected volatility to increase in 2018, but perhaps not by so much in one day.
The time-series of volatility suggests that a spike is followed by a sustained period of higher (although not necessarily extreme) volatility and we expect this to be the case in this instance. The fundamental driver for increased equity market volatility remains in our view the re-normalisation of monetary policy and the consequent return of volatility to interest rate markets. It remains to be seen how much portfolio de-risking will be required in coming days from funds which explicitly or implicitly target a specific level of volatility.
We do not subscribe to the view that rising bond yields are “responsible” for the recent surge in market volatility and index declines. Yields were at the start of 2018 inconsistent with continued strong economic growth and both policymakers and institutional investors would have known this. Instead, we believe recent events more closely resemble avalanche risk. The long period of low volatility and confidence in a rising stock market had engendered a complacent market structure liable to fracture with very little provocation.
In fact, the equity market declines to date have been modest, with the S&P 500 for example now down 8% from the high but trading at the same level as recently as December. Thus, market valuations which were previously extended have eased somewhat but are still not below long-run averages. The declines in the stock markets to date also would not in our view represent an implicit financial tightening which would materially alter the direction of Fed rate policy.
Recent economic data such as US services PMI or German industrial orders remain robust even if economic surprise indices are a little lower than the peaks in December. Therefore, the overall market picture is little changed in terms of long-term expected return and no reason to materially alter portfolio positioning for now. However, active managers are more likely to be able to find individual alpha generating opportunities as volatility targeting investors re-position portfolios to account for likely higher market volatility in coming quarters.
In volatile markets, it is very tempting to judge the merit of an investment on potential short-term performance and this contributes to the demand for commentators to explain why a particular level or event might represent the “bottom of the market”. Such a short-term focus can also paralyse investment decision-making.
We cannot with any certainty predict such a magic level and therefore make no prediction on short-term market direction. Instead, we believe investors are better served in volatile times by remaining focused on company fundamentals, where the economy is in the cycle and the likely long-term expected return on any investment.
