The Return of Volatility

While it was only two weeks ago that we heard the incessant chatter about “the best January in the last three decades”, it may as well have been a lifetime. From February 2nd through yesterday (February 14th), the average range (high minus low) of the Dow has been 791 points (or 3.2% of the opening value). By comparison, the period from 1/1/2017 to 2/1/2018 saw an average range of 115 points (or 0.5% of the opening value). It is also interesting to note that the market was up for 58% of the 273 trading days which is remarkably high even compared to other bull market periods. It gets even crazier when we focus on the last half of that period where the market was up for 67% of the 137 trading days. Indeed, it felt quite unnatural to repeatedly ask, “How much was the market up today?” rather than the usual, “Was the market up or down today?”

Aside from the entertainment value of watching the CNBC pundits tie themselves into rhetorical knots trying to explain the market movements in relation to interest rate changes (spoiler alert: they can’t), there are sound reasons to welcome the return of volatility.

First, volatility is a primary measure of risk, and risk is the reason why we have an expected return from equities that is higher than the risk-free rate of US Treasury bills. The additional expected return of equities is known as the risk premium. While we don’t expect it to be as high as its historical average of about 6.6% (from 1926 to 2017) due to today’s high valuations, we still expect it to be high enough to justify taking on the volatility associated with equities.

Second, if this onset of high volatility portends a bear market, then stocks will return to their rightful owners (i.e., long-term investors who are capable of holding them through all types of markets). We don’t expect anytime soon to see headlines like “Retail Investors Jump into Market” from the Wall Street Journal of 1/27/2018, just before the roller coaster ride began. What a coincidence!

As wild a ride as it has been the past two weeks, it is worth noting that we are about where we were at the beginning of the year. As of the close on 2/14/2018, the Dow is up 0.7% year-to-date, and the S&P 500 is up 0.9%. For investors with balanced portfolios who have not rebalanced, it is not too late. Here is one way to think about it. Suppose the market went up 1,500 points in one day and then reversed itself the next day. Should anyone feel stupid for not taking profits on the up day? Of course not! So instead of a 2-day period, we have only had 31 trading days for 2018 where the Dow took a similar round trip.

If you have any questions or concerns about investing in this market with the re-emergence of volatility, please feel free to call us at 800-345-4635 or email us at info@clarityca.com.