Schwab Market Perspective: Volatility…it’s Back!

Key Points

  • The long-awaited return of volatility has arrived, unnerving investors. But economic and earnings fundamentals remain strong and this is part of the process of returning to a more “normal” market environment.

  • The U.S. economy is showing improving growth, earnings season has been strong, and earnings expectations for 2018 have surged; but expectations are elevated and the rate of improvement in both is likely to slow.

  • Global stocks were not spared but the fundamental picture internationally also looks solid.

It’s Back

In what has been a long time in coming, but took some investors by surprise with both the timing and the violence of the move, volatility returned to the stock market in the last couple of weeks. To investors who became accustomed to the low-drama market environment, it may have come as quite a jolt. After all, we just saw the first back-to-back declines in the S&P 500 in 310 trading days! The spike in volatility led to a massive unwinding of “short vol” (short volatility) positions as well as forced selling of other securities or assets to cover their short positions. The short-vol trade had taken over from the “long Bitcoin” trade as of the end of January, according to a recent Bank of America Merrill Lynch fund managers’ survey and its unwinding led to a technical kicker to a selloff which began on fears of higher interest rates.

Volatility spike contributed to more volatility

Something or nothing?

The bigger concern is whether the recent selloff in stocks is a harbinger of more serious and long-lasting damage to come. Although we don’t yet know the extent of the carnage within and associated with the short-vol space, we do believe the recent pullback is healthy for the continuation of the bull market. Recent action has allowed extremely stretched sentiment conditions to correct somewhat. According to the Ned Davis Research (NDR) Crowd Sentiment Poll, investor optimism has come off the record highs seen a couple of weeks ago. We believe some of the recent action is part of a process of resetting investor expectations to more reasonable levels. Business optimism has come in a bit as well as we’ve seen some downticks in manufacturing surveys, which indicate continued strength but at a slightly more modest pace.

Manufacturing still strong, but a modest downtick

A precipitating factor which underpinned the initiation of this corrective phase was a spike in the 10-year yield to above 2.8% and rising expectations for a faster pace of rate hikes by the Federal Reserve. The concern boiled over following the release of the recent labor report that showed average hourly earnings rose 2.9% year-over-year, the highest rate of growth since June 2009, leading to the thought that the Fed may have to be more aggressive. Although we do think the landscape for wage gains to translate to higher inflation, the severity of the market move may have exaggerated the impact of the wage increase; and several Fed speakers have recently expressed the belief that higher wages won’t necessarily lead to significantly higher inflation (James Bullard-February 6 and Robert Kaplan-February 7-both reported by CNBC).