ECONOMIC COMMENTARY

Volatility picks up after a year-long hiatus

By many accounts, 2017 was the year where volatility disappeared. Let’s take a closer look at our observations:

  • The CBOE Volatility Index (VIX) dropped over 20%.
  • The S&P 500 only experienced 4 trading days lower than -1% and another 4 days greater than +1% . The S&P 500 also did not experience a single trading day lower than -4%, which the index hadn’t experienced since 2006.
  • Since 1980, the average intra-year decline for the S&P 500 is just shy of 14%. In 2017, the largest period of decline for the S&P 500 was 3%.1

While 2018 started out much the same, there was a major shift in late January:

  • As of February 16th, the CBOE Volatility Index (VIX) had risen over 76% in 2018.
  • From January 26th to February 16th (16 trading days), the S&P 500 had already surpassed 2017 with 4 trading days lower than -1% and 6 days greater than +1%. Since 1999 the S&P 500 experienced on average about 37 combined days lower and greater than -/+1% annually.
  • The largest peak-to-trough decline for the S&P 500 so far in 2018 has been 10.2%.

What caused the recent volatility?

We believe the primary catalyst was a fear of rising inflation and interest rates. Very simplistically, if inflation rises more, or faster, than expected, the Fed is more inclined to quicken its pace of raising interest rates. Higher rates may cause a ripple through the economy and the equity markets. It is still too early to predict what policy the new Fed chairman will enact, but the old leadership was pretty clear on its “slow and steady” messaging when it came to tightening policy.

Fundamentals are not really a factor (yet). Corporate earnings are coming in mostly higher than expected and tax reform still presents a potential tailwind. Most economic data is benign to solid.

However, equity market valuations remain historically high by most metrics. While not necessarily the root cause of higher volatility, it is reasonable for investors to exhibit certain levels of fear given we are now more than 9 years into this bull market cycle. As long-term investors we do not attempt to time the market peaks and troughs, but are acutely aware of the risks inherent in markets valued at today’s levels.

What are we doing with client portfolios?

  1. We typically stay the course. We believe that market timing and emotional investing based on short-term dynamics will deteriorate long-term returns. We want our clients to be long-term focused investors, which can only truly occur with proper liquidity and financial planning, and a genuine understand of risk.
  2. Added volatility may present a good entry point into the market. For many of our clients who are either holding excess cash or experienced a liquidity event, lower valuations might present a compelling investment opportunity. The challenge, similar to what we experienced with the Brexit vote, is that the open window may have been too small, too short or both.
  3. In some situations, specifically where a client’s risk profile has changed, we might “de-risk” the portfolio. This is usually accomplished by adjusting the allocation slightly away from growth assets to defensive assets. Volatility will be reduced, but so will expected long-term returns. This is less a reaction to volatility as it is to client situation and risk profile.

Putting new money into the stock market is the most challenging exercise in periods of high valuations and volatility. While staying the course is prudent for fully invested portfolios, it might not be for all cash portfolios entering the market for the first time, which we see often with founders, executives and investors. Entry point is important to long-term returns as risk is generally not compensated when money is invested at the peak of a market cycle. In these situations we often look to either tactically reduce portfolio risk or hold a portion as “dry-powder” to deploy when appropriate.

Similar to venture capital investors and founders of startups, we take a long-term view on investing. Tracking daily price fluctuations in any investment can drive you crazy. Proper diversification is our primary defense of volatility. With a well-defined financial plan, periods of increased volatility should not worry us or distract from our long-term goals.

1. Source: JPM Guide to the Markets, 12/31/2017

Thomas O’Keefe is the Head of Investment Strategy, responsible for portfolio construction, manager due diligence and market insights. He is focused on driving investment solutions at a firm and client specific level.

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