The first quarter of 2018 marked the return of the kind of volatility that investors have not seen for some time. In just the first ninety days of 2018, the S&P had 25 separate sessions where prices moved up or down more than 1%. This compares with only 10 such moves during the entire course of 2017 (see chart below). Thus, in the first few months of this year, investors are being treated to almost three times the level of volatility experienced in all of 2017. If last year was an unusually quiet ‘kiddie’ ride at the park in volatility terms—2018 by comparison is a return to more ‘thrills and chills.’
After a +9% move higher in the S&P 500 through the first three weeks of January, it has been mostly downhill for stocks as the S&P logged its first quarterly loss (-0.76%) since 2015. The context for both volatility and a pullback should not be that surprising or difficult to understand—even if it is happening against a favorable economic backdrop for most of the companies we own for clients. It’s helpful to frame this in terms of the three ways investors make money in stocks:
- earnings grow (or shrink),
- dividends are paid,
- investors’ willingness to pay for future earnings and dividends changes (i.e. valuation greed or fear).
It’s never the same combination in any one year. The good news for 2018: corporate earnings appear capable of robust growth of +15% or more—in part due to lower corporate taxes from the recent Tax Cut & Jobs Act, but also due to improving global GDP growth in each of the three largest economic zones. Dividends should also grow nicely. So why does the market suddenly feel so bipolar?
The answer is #3. Investors are feeling much less sure about what to pay for future earnings and dividends. Volatility has recently been serving as a healthy ‘check’ on valuation and investor complacency. The main valuation measure of stocks—the price-to-earnings ratio (or “P/E”) of the S&P 500—has been contracting even as earnings expectations have risen—the P/E for 2018 stood at 20.3x at the end of last year but now sits at 16.2x, which is more in line with the average over the past two decades. Both the pullback and heightened volatility share a common theme—greater uncertainty.
The greatest cause of uncertainty is fear of inflation and rising interest rates. The yield on the 10-year Treasury has moved up to 2.8%, about 40% higher in just a 6-month span. The level of interest rates is not the problem (still extremely low by historical standards), it’s more the pace of the increase and the concern of the ultimate level of rates. Inflation and Federal Reserve rate hikes have been non-factors for most of the past decade. Both issues are now part of the daily conversation in markets, which takes some getting used to.
Second issue: Washington. The revolving door of cabinet members and staffers has made for bizarre theatre at times, but it’s far less important to stocks in our view than the recent Trump foray into more confrontational trade policy. The administration’s stand on tariffs, NAFTA, and Chinese intellectual property theft have injected more uncertainty into markets and investors have become concerned about a trade war induced global economic slowdown. However, we believe there’s a high probability all of it could prove to be bluster in search of a negotiating ‘edge’ as part of new trade discussions. If this proves to be the case, the dire consequences investors have imagined could be avoided and the focus could return very quickly to corporate earnings growth.
Since the financial crisis of 2008, investors have had it easy. The road to higher prices and compound annualized returns of greater than 18% since March 2009 has been relatively smoothly paved. Despite, periodic spikes in 2011 and 2015, volatility has been surprisingly tame for much of the past 15 years. Last year was an anomaly in that the market appreciated so consistently without any corrections. However, we believe that the return of a more pitched battle between fear and greed is not a bad thing—it’s a fundamental reminder that volatility is the norm—a necessary price investors have paid for the much higher returns stocks have provided versus other asset classes.