ETF Store Insight

Changing Back to Normal

April 9th, 2018 by Nathan Geraci

Nathan Geraci is President of The ETF Store, Inc. and host of “The ETF Store Show“.

A key theme in the stock market last year was a lack of volatility.  For the first time ever, stocks were positive in all twelve calendar months and experienced only eight days with up or down moves exceeding 1%, one of the least volatile years on record.  2018 began on a similar note, with stocks racing out of the gate and volatility nonexistent.  The environment shifted abruptly in early February as stocks plummeted 10%+ with a historic spike in volatility.  Since then, the ride has been a bumpy one for investors:  through the end of March, the S&P 500 has already seen twenty-three moves of at least 1%.  Stocks experienced their first quarterly decline since the third quarter of 2015.

Source:  Charles Schwab

 

The rising volatility has been attributed to any number of factors including rising interest rates, fear of inflation, the unwinding of the Fed’s balance sheet, potential trade wars, tech stocks plunging on concerns over data privacy and government regulation, and continued political turmoil in Washington D.C.  Additionally, though corporate earnings remain strong, there is evidence that the magnitude of improvement has slowed.

Making investors even more uncomfortable has been the lack of refuge typically provided by bonds, which experienced declines across the board during the first quarter.  Interest rates and bond prices move in opposite directions.  As rates rise, bond prices fall – both of which have occurred thus far in 2018.  Investors typically view bonds as a safe haven, providing cushion when stocks decline.  However, an environment of rising rates and growing inflation concerns can create a short-term headwind for both stocks and bonds.  The bottom line is it seems change is in the air.  Stock market uncertainty and volatility is back with a vengeance and rising rates and inflation are a growing concern for bond investors.

 

“The more things change, the more they stay the same.” – Alphonse Karr

There are three important takeaways for investors:

1) The stock market environment is changing, but it’s changing back to normal.  The lack of volatility experienced in 2017 was far from normal.  According to CFRA’s Sam Stovall, the average number of 1% up or down days for the S&P 500 is fifty-one.  2017 had eightWe mentioned last quarter that volatility is a normal part of investing in stocks and, as an investor, you should be mentally and financially prepared for it.  The stock market is simply getting back to its usual self – where volatility actually exists.  More importantly, remember that while volatility is often equated to risk, the real risk for investors is unnecessarily avoiding the stock market and falling short of financial goals.

2) The bond market – changing back to normal as well!  After years of declines, interest rates are back on the rise – trending towards more normalized levels.  The bond market has experienced mostly falling rates (and thus rising prices) over the past 35+ years, which has resulted in an extended bull market for bond investors.  A meaningful, longer-term uptick in rates would certainly be a new experience for many investors, but one that would move rates closer to their historical average.

Source:  JP Morgan

 

While rising rates may cause some short-term pain for bonds, they can be beneficial over the long-run.  Rising rates can equate to greater income for yield-starved investors, and the growing income from higher yields ultimately may trump short-term capital losses.  Also, there is no shortage of fixed income holdings that may react well to rising rates and inflation, such as investment grade floating rate notes and Treasury Inflation Protected Securities (TIPS).  The key is owning a well-diversified mix of bonds, with an overall allocation that targets the appropriate level of risk in a portfolio.

3) The financial media never changes.  Fear sells.  It was noteworthy that during the first quarter, the financial media treated a 10% stock market correction as if the apocalypse was upon us.  For some historical perspective, over the past 38 years, the average intra-year drop in the S&P 500 has been 13.8%!  The media would have you believe a 10% correction is out of the ordinary.  Tune-out the noise.  All of the current media talking points – rising rates, inflation, removal of Fed stimulus, trade policy, politics – can be spun both positively and negatively to fit a narrative.  Avoid allowing outside influences and narratives to calibrate your portfolio risk for you.