Is the Current Mild Market the New Normal?
One of the most popular story lines of 2017 was the unprecedented lack of volatility in the stock and bond markets, despite a wide range of worldwide events that would typically be disruptive. So how long can this mild investment environment last?
Volatility indicates the fluctuation in a stock’s value over time. The CBOE Volatility Index (VIX) is a leading measure of market expectations of near-term volatility conveyed by S&P 500 Index (SPX) option prices. A value over 30 is considered high. But until very recently, the VIX was below 10, and has stayed near record low levels most of the year. Investors have apparently shrugged off the risks of a nuclear war with North Korea, multiple natural disasters and mass shootings, tightening monetary policy, plus a great deal of uncertainty about future tax and trade policies.
As a result of this low volatility, making money by staying invested in stocks and bonds was pretty easy in 2017. Consider these ground-breaking stats:
- Last year was the ninth in a row when the S&P 500 has finished with a gain, something that hasn’t happened since the late 1990s.
- It was the first calendar year when stocks have gone up each month.
- Going back even further, December was the 14th consecutive month with positive returns, which also has never happened before.
- We only experienced eight days when the market moved up or down 1% or more. This is highly unusual and by this measure, 2017 was the least volatile year since 1964.
- The S&P 500’s average daily change on an absolute basis was just 0.3%. This is the smallest number in more than 50 years.
- The biggest decline last year was a drop of 2.8% in March/April. Again, this is not normal as it is far below the historical average for the S&P 500, which typically experiences a drop of about 14% at some point each year.
It’s not supposed to be this easy
It’s normal to see market corrections (declines of 10% or more) occur once every year or so, and bear markets (declines of 20% or more) have typically happened approximately every five years. However, the current bull market is now more than eight years old, and we’ve had only five corrections since 2009.
The last correction was nearly two years ago, and the S&P 500 has grown almost exactly 50% since. U.S. stock prices have risen in 29 of the last 34 quarters, and investors have gotten used to seeing their portfolio values go up (and up and up) with just a few interruptions. Because it has been over two years since stocks have fallen in a quarter, we’re concerned that investors have begun to think that this is normal. It’s not.
Investors in the stock market should expect volatility, including corrections and even bear markets from time to time. Experience teaches us that volatility is a feature of the stock market, not a bug. Under normal conditions — in a world where markets are fairly valued — stocks should produce returns that are higher than bonds, but they should also have a higher risk of loss.
Despite what we experienced last year, we don’t believe that stocks have permanently become less risky. We anticipate volatility returning to more normal levels at some point in the future, and that will likely include a meaningful decline. Investors are calm and optimistic now, but this environment won’t last forever. The pendulum will swing back toward pessimism eventually, and when that happens, volatility could return quickly.
The economic expansion could continue
This is not a prediction that stocks will decline in the near-term or that a bear market is coming soon. Bear markets almost always coincide with a recession, but all the leading economic indicators continue to suggest that the risk of recession remains low.
The recent strong investment returns and low volatility are both the result of low interest rates and easy monetary policies. Even as the Federal Reserve Bank continues to reign in its easy money policies, the global economy remains awash in liquidity, and economic growth is expected to continue in 2018.
Investors in the stock market should expect volatility, including corrections and even bear markets from time to time.
Economists often say that economic cycles and bull markets don’t die of old age. Instead, cycles usually end due to some unexpected shock, or after the Fed raises rates too far and causes the economy to slow. While the current U.S. economic recovery is much longer than average, there have been two other expansions that have persisted even longer. The boom period during the 1960s lasted 106 months, and the technology-led 1990s expansion continued for a full 10 years without a recession.
Economic growth during the current recovery and expansion has been slower than normal, but it has persisted. Corporate capital spending has not returned to its prior levels, but recent merger and acquisition activity indicates that businesses may now be willing to re-invest some of the ample free cash flow they generate from operations. We are hopeful that this trend will continue, and that increased business investment unlocks higher productivity and leads to faster economic growth. We are also somewhat optimistic that fiscal policy out of Washington may help provide at least a near-term boost to economic output.
Yet risk management is still necessary
Periods of healthy stock and bond market returns, along with low volatility, may lead investors to develop unrealistic expectations. Looking only at the last eight years, it would be natural to think that investing in stocks is safe and easy. We think investors who succumb to this view are underestimating the risk in the stock market, and this could set them up for disappointment in the future. Aspiriant Chief Investment Officer John Allen further explains the risk of emotional investing in Foundational Elements: Speculator or Investor?.
For our part, while we are optimistic about the economy on a long-term basis, we are also aware of the risks that accompany investing in the stock market. Even if other investors have been lulled into thinking that risk management is not necessary, we have learned from experience that we should only take investment risks when we expect a satisfactory reward.
In summary, even though market volatility has been extremely low, and investment returns have been smooth, we feel that it’s best to position portfolios somewhat defensively. This means a diversified mix of assets that are not strongly correlated with others and, therefore, are expected to be less volatile during a market correction.
While some investors may be tempted to extrapolate the recent past into the future and expect continued smooth sailing ahead, we have not forgotten that the need for risk management never goes away.
Past performance is no guarantee of future performance. All investments can lose value. Indices are unmanaged and you cannot invest directly in an index. The volatility of any index may be materially different than that of a model.
The CBOE Volatility Index® (VIX® Index) is a leading measure of market expectations of near-term volatility conveyed by S&P 500 Index (SPX) option prices.
The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. The index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. It focuses on the large-cap segment of the market; however, since it includes a significant portion of the total value of the market, it also represents the market.