Should We Be Worried About The Five-Decade Low In Market Volatility?

Richard Nixon was in the White House the last time there was this much calm in the U.S. stock market. In the second week of August, the 10-day rolling volatility of the S&P 500 Index went to just 2.43%.

In five decades, there has not been such an absence of volatility and it is this that is sparking concerns that investors are overly complacent.

Are such concerns justified?

Although the lack of turbulence has been going on for some time, these worries are perhaps being increasingly aired now as late summer and early autumn have often been difficult times for U.S. and global stock markets.

The global financial crisis, which began in September 2008, is perhaps the most extreme example of this seasonal phenomenon in recent decades. But many of us will also remember Black Monday of October 1987, the Asian financial crisis that started in July 1997, the Russian default of August 1998 and (the relatively modest) China devaluation shock of July and August 2015.

So, should we be nervous of a similar shock this year?

It is difficult to identify a potential trigger to such a shock. The U.S. economy is currently growing at an annualized rate of around 2.5%, helping to drive the expansion of corporate earnings. The U.S. financial system is in good health, with well-capitalized banks, even if there is some nervousness over the auto and student loan sectors.
A recovery in Eurozone consumer demand, and a stronger euro, are helping support American exports.

And with U.S. and global bond yields still so low, it is difficult to argue that any market shock will cause a sustained flight out of equities. Where would investors go with their money?

Finally, domestic and international news flow has been better than many investors had expected at the start of the year. The Chinese economy has not succumbed to a bad debt-induced recession, European political populism has lost momentum, and Trump has not – so far – done significant damage to global free trade.

But financial markets, and actors within them, are notoriously unpredictable. A late summer/early autumn shock seems unlikely at present, but that is no reason to become complacent. We should always have a diversified approach to investing: one that includes a variety of asset classes and exposure to global markets, not just to the U.S.

So where are the risks? Federal Reserve policy risk, declining corporate earnings and an overvalued tech sector dominate concerns on Wall Street.

U.S. equities’ attractiveness relative to bonds and bank account cash rates might quickly disappear should the Fed normalize interest rates back to 3% or more. This seems to me unlikely, given the absence of an inflation problem in the U.S., but policy error from an over-enthusiastic Fed is a risk.

Some commentators also point to declining corporate earnings growth in many sectors, aggravated by weak investment spending contributing to low productivity growth. Indeed, some commentators argue that capitalism needs to see wages rise as a proportion of GDP, causing profits to fall, in order to see meaningful consumer demand growth in the years ahead in the absence of a Trump-led fiscal stimulus.

As industrial and other sectors have adjusted to the growing likelihood of Trump not delivering the economic stimulus promised on election, the gains made this year by the S&P 500 Index have been driven by a narrow band of sectors, led by tech, and reminiscent, to some, of the TMT bubble of the late 1990s.

It may be that the rally this year for the FAANGs (Facebook, Apple, Amazon, Netflix and Google) is justified. These companies intend to dominate future I.T., from driverless cars to artificial intelligence. But investor sentiment can turn quickly against growth-orientated companies during periods of general market risk aversion.

I expect further gains on Wall Street this year. Equities will be supported for the rest of the year by corporate earnings growth, reflecting a combination of reasonably strong domestic demand growth and a weak dollar that supports exports. In addition, further modifications to the Fed’s interest rate projections can be expected as CPI inflation remains subdued in the absence of a major fiscal stimulus from the Trump presidency.

However, volatility may rise, as investors become more nervous over the ability of the FAANGs, in particular, to sustain their valuations.

But I see no potential trigger likely to cause a sustained downturn on U.S. and global stock markets over the rest of the year. As always, investors should remain diversified and – if volatility does increase – not panic, but buy into falling stock markets in order to maintain market exposure.

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