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Now What?

| February 06, 2018

It has been a recurring theme lately, in our conversations with clients and friends, that equity markets were quite overdue for normal and expected downside volatility. Well, the month of February has certainly delivered on that score, and complacent investors find themselves suddenly reacquainted with queasy sensations reminiscent of 2016, 2011, 2008, 2002 and other infamous periods in market history.

Periods of heightened volatility in the markets can lead to the greater risk of bad decision-making, permanent capital impairment and real lifestyle harm into retirement.  In our experience, sometimes the best cure for high anxiety is good old-fashioned data that puts temporary market gyrations into proper longer-term perspective and helps us navigate the current volatility wisely.

First off, it must be said again that 2017 was an unusually good year for the U.S. market, and not only for the obvious reason that all major indexes were up.  Last year was extraordinarily “calm,” in that downside volatility was almost non-existent. For example, the action of the past week breaks a string dating back to November 2016 since we last saw even a 3% correction in the S&P 500. Until last Friday, markets had gone 331 trading days (about 16 months) since the last two consecutive days of even a 0.5% correction.

Compare the lack of downside drama in 2017 with the reality that, over the past 100+ years, the S&P 500 has experienced, on average, over 3 corrections of at least 5% per year.  We could go on, but the point is clear. Looking back at over a century of trading data, the recent stretch of seemingly riskless gains in risk assets was highly unusual and bound to come to an end.

Without going into too much detail, the main culprits for the roller-coaster ride of the past few days are short volatility funds that make leveraged bets on calm markets and use derivatives to track their benchmarks. Those trades have obviously blown up this past week as volatility has spiked. In our opinion, this is not a bad thing going forward if the demise of such funds discourages lengthy periods of complacency in the market.

History may be on the side of the market here. We have recently experienced about an 8% correction after a rally that lasted well over 300 days. Historically, after similar moderate corrections (5-10%) following long rallies of at least 200 trading days, the S&P 500 was up an average of 3.4% one year later. The end of long rallies have not typically coincided with cyclical bull market peaks

Long-term history suggests that volatility should increase back toward historically normal levels, but it does not mean that the cyclical bull market has come to an end.  Most major peaks form via a topping process. They are preceded by failed rallies, where the popular averages charge ahead or grind higher, but fewer and fewer stocks participate. There is not yet enough evidence to support the contention that a topping process is starting.  If this is a topping process, additional rallies should allow for opportunities to reduce exposure to equities.

We will continue to monitor the relative performance of stocks versus bonds, interest rate movements, equity valuations compared to bond yields, trading sentiment and other key indicators that will determine our asset allocation recommendations across all risk tolerances going forward. For now, longer-term equity uptrends remain unbroken.

Information from Ned Davis Research was used in generating this piece.