Returning to the “Old Normal”

February 15, 2018  | by Ryan Driscoll, Michael Strauss

Equities | Industry Knowledge | Market Commentary

Summary

  • Volatility returned to the equity markets in February after an extended period of unusually low levels

  • While the exaggerated swings in equity markets are disconcerting, they are likely a result of investors grappling with too much complacency, rather than a reflection of any negative turn in the economy or fundamentals

  • Company earnings continue to show strength which is supportive of equity markets going forward

  • The return of volatility could be a boon for active managers, who have been challenged by its absence in recent years

Investors took solace in the lack of stock market volatility in 2017. In reality, that may have been more of an anomaly than the current turbulence equity investors are experiencing.  Volatility spikes in the capital markets are not unusual. Similar occurrences have happened throughout the bull market recovery since the “Great Recession”, most notably the “Flash Crash” of May 2010, the “Summer of Volatility” in 2011, and the “Brexit Fears” in June 2016.  Entering 2018, stock market volatility was unusually low for several months and years. The S&P 500 Index five-year rolling volatility declined to less than 10 percent and during 2017 it was less than four percent, versus 25 year average volatility that was closer to 13 percent.  This abruptly changed last week.  A portion of the blame for the selloff came from signs that the U.S. is returning to a normal economic cycle, whereby stronger growth and earnings are likely to spark a modest pickup in inflation and the Fed-induced responding with higher interest rates. Added to this is concern about increased pressure coming from aggressive Fiscal stimulus late in the cycle.  However, the hidden culprit could have been the reversal of too much complacency, with market participants finally recognizing that the extended period of extremely low volatility is being replaced by a return to the “old normal.”    

For 2017, the S&P 500 Index completed a 12-month period of consecutive monthly positive total returns for the first time since 1950 – 67 years.  Likewise, downside deviations in the stock market were limited as the S&P 500 Index did not post a two percent down day during the year, versus what would typically be seven or eight  two percent down days in a year. This abruptly changed in early February 2018. 

The VIX[1] index was below 10 in mid-January and gradually rose to the low teens at the end of January.  On Friday, February 2, the S&P 500 Index ended its longest streak on record without a three percent correction and by February 5, the S&P 500 Index declined five percent below its recent peak for the first time since the Brexit fears in June 2016.  Ultimately, the VIX spiked to 50+ at a time when many market participants had become anesthetized to the low volatility registered the last several years.  The surge in the VIX was remarkably consistent with previous sell-offs of this magnitude, notwithstanding 2008/2009 when the “Great Recession” unfolded.  Even so, the rise in volatility fueled waves of selling last week in part due to margin calls to cover short volatility positions in the equity market and risk parity strategy adjustments.  The partial rebound in stocks late last week, after testing the long term 200-day moving average support, and the slight moderation in volatility could be a sign that the worst of the pullback is behind us.

CH1-VIX-Index

Where do we go from here?

Despite the recent events, a rebound in economic activity and earnings, combined with a back-up in market interest rates and inflation for the “right” reasons (including strong demand and wages going up as a result of improved corporate profits), suggest that the period of a highly accommodative monetary stance is likely to come to an end in 2018.  Similarly favorable macroeconomic conditions unfolding in Europe and Asia show that the period of benign central bank policies is likely to change outside the United States this year as well.  This should help to hasten the transition from a gallop to a grind that we wrote about in January.

CH2-Historical_volatility

At the end of 2017, one-year volatility for equities was less than one-half (and for several asset classes less than one-third) the volatility experienced during the last 25 years.  The abrupt change in volatility in early February has been challenging; however, an important factor that historically drives equity returns, earnings, remains extremely positive.  With about 68 percent of the S&P 500 companies reporting, more than 81 percent are beating estimates, with yearly earnings accelerating at a robust 15+ percent pace. 

Looking forward, solid economic growth and the reduction in corporate tax rates is likely to provide an 18 to 20 percent increase in earnings in 2018.  Thus, the S&P 500 Index appears to be trading at less than 17 times 2018 earnings.  This is above the historical average of 15.7, but the higher valuation may be justified by the record amount of cash on corporate balance sheets, the likely repatriation of billions from overseas corporate profits, and the extremely low returns from U.S Treasuries. Moreover, corporations may use the current period of market indigestion as an opportunity to initiate stock buybacks with repatriated foreign earnings. 

Active Management Benefits from Higher Volatility

Low levels of volatility are generally supportive of broad equity and credit market returns but can often be a headwind for active equity managers seeking to take advantage of security specific pricing inefficiencies.  Conversely, slightly higher levels of volatility may expand opportunities for active stock pickers but often in a lower overall return environment due to the likely moderation in P/E multiples.  We recognize that the events that unfolded at the start of this month may represent the beginning of a move to higher volatility than what has been experienced over the past year as interest rates, inflation, and economic conditions normalize.  Nonetheless, we are somewhat encouraged that the VIX index tempered to less than 30 at the end of last week.  And, as the spike in volatility continues to moderate towards the long term volatility experienced over the last 25 years, the equity market should rebound and return to producing more singles and doubles, rather than the either the waterfall selloff of the last week or the homeruns of the past two years.

[1] The Chicago Board Options Exchange Volatility Index reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes.

Authors

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Ryan Driscoll is responsible for trading, investment analysis. He is a member of the Treasury Solutions team since its inception. Ryan is an active participant in the investment and rebalancing process, manages the quarterly reporting process and is actively engaged with Treasury clients. Prior to joining Commonfund, Ryan worked at Sailfish Capital Partners, a multi-strategy fixed income fund, where he served on the Emerging Markets team. Prior to that, he was on the fixed income team at Grantham, Mayo, Van Otterloo & Co. and was an equity/fixed income trader at Loring, Wolcott and Coolidge, in Boston. Ryan received his B.S. in Finance and M.S. in Global Financial Analysis (with Distinction) from Bentley College. He is a CFA Charterholder and is a member of the Boston Securities Analyst Society and CFA Institute.
Ryan Driscoll
Director, CFA
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.