Volatility Is Back: What to Do Now

Some form of near-correction may have been inevitable, given how “frothy” markets became. Investors grew overly complacent, watching their equity holdings soar up and up with unusually low volatility (you have to look back to 1964-’65 to find a similar period). This underreaction may have turned to overreaction, which is typical human behavior. Market corrections are normal. Bloomberg data from the last 30 years shows they generally occur every 15-18 months[1], but it has been roughly two years since the last. That can make it feel particularly painful.

After months of lagging, volatility swiftly re-emerged. The CBOE Volatility Index (VIX) surged almost 260% since Friday, achieving its largest percentage rise ever on Monday, at 115.6%. The VIX closed Monday at 37.32, above its 10-year average for the first time since Nov. 4, 2016. Early Tuesday it briefly rose over 50, the highest level since August 2015.

According to Jefferies: Since 1990, once the VIX closed above 40, it took a median of 114 days to drop below 20; and once the VIX closed above 50, it took 306 days to fall below 20. It can be challenging to predict when market volatility will strike, even with positive fundamentals.

Conventional wisdom suggests volatility surged and markets rattled amidst concerns of rising:

• U.S. inflation, as wage growth accelerates (the U.S. Department of Labor released a better than expected year-over-year wage growth figure)
• Interest rates (10-year U.S. Treasuries hit their highest level since January 2014), which can effect mortgage rates, credit card debt and ultimately consumer spending

Investors suddenly appear to be concerned that we moved from a goldilocks environment (“not too hot, not too cold”) to an overbaked “too-hot” economy. If this does cause inflation to rise, the U.S. Federal Reserve could pursue more interest rate hikes in a shorter time frame. Getting monetary policy right is very hard and the Fed could slam the brakes on U.S. economic growth. The U.S. economy is already running at capacity constraints, thanks to full employment. The fiscal stimulus of corporate and individual tax cuts may have put us over the edge to unsustainable growth.

There are other risks. With such high valuations (the S&P 500 price-to-earnings ratio is at 22, the Schiller P/E at 32), investors’ expectations of growth may be unrealistic. In addition to risk of overly aggressive interest rate increases, political risk is also worrisome. Our political divisions could give investors pause given necessary budget approvals and constant battles to extend the debt ceiling. Geopolitical risks bubble away, including potential U.S. trade policy changes – especially NAFTA.

Where will U.S. equity markets go from here? Let’s get through this week, then ask again.