The Return of Risk

  • April 4, 2018

BY: Jim McElroy, SVP-Investments

jmcelroy@argentfinancial.com

Throughout 2017, as the S&P 500 powered to a 20% total return, volatility, as measured by the CBOE VIX index, remained mostly below 15 and seemed to be glued to a level of 10. The VIX price is calculated by solving for the assumed volatility of the S&P 500 index. This, along with interest rates and expiration dates, determine the price of related options. The VIX price is the market’s expectation, expressed in percentage points, of the annualized future volatility (or standard deviation) of the S&P 500.

Since at least as far back as 1928, the average volatility of the index has been about 21%. In 2017, volatility was a little more than half its long-term average. Volatility tends to register in the lower reaches of its long-term range when the market is moving mainly in one direction, particularly when that direction is positive. It’s no surprise that volatility increases when a reversal of direction occurs. In February of 2018, there was a reversal.

The correction — a market that loses at least 10%, but less than 20%, from its previous high — which began in February (it actually began in the last three days of January), was the fifth since the current bull market started its run in early March of 2009. So far, the current correction is the shallowest of the five: its maximum decline of 10.2% is barely a correction in the S&P 500 and, according to the Dow, the peak to trough loss was only 9.4%. If a bull market lasts long enough, one can expect multiple corrections before a bear market (down 20% or more) makes an appearance.

Since 1928, there have been twenty-one bull markets, lasting an average of 2.7 years. The longest bull market since 1928 ran for twelve years and four months (from 12/4/87 to 3/24/00), had five corrections and gained 582%. The current bull market is the second longest since 1928 — nine years so far — and has gained 290% through the end of March. It is tempting to view markets in terms of time — after a certain number of years and a certain number of corrections, it must be time for a bear market — but markets don’t operate this way. It’s true that they’re driven by mass psychology, but the psychology is influenced by real and imagined events, and particularly economic events, which occur or are rumored to occur in the real world.

The 20% return for stocks (S&P 500) in 2017 was due in large measure to the optimism that surrounded a new administration in Washington, which promised to encourage growth and discourage stifling regulations. By the end of the year, the new administration had delivered on its promise of tax reform with tax cuts, domestic GDP was beginning to rise above its recent sub 2% growth (2.9% in the fourth quarter), the global economy was showing signs of renewed life post Brexit, the Federal Reserve was gaining confidence that its return to normal interest rates would not precipitate deflation or another recession and consumer confidence had returned to expansionary numbers. At the close of 2017, all seemed right with the world. So, why the correction in the first quarter of 2018?

The quarter certainly began well enough: the S&P 500 gained 6.7% from the end of December and set a new record on January 29th. Then a series of concerns began to circulate.

The Fed, now under new management, reported that the economy appeared to be growing at a somewhat faster rate than originally thought and that they anticipated lifting rates (currently between 1.5% and 1.75%) to about 2.9% in 2019 and to about 3.4% in 2020. This, to some investors and pundits, seemed a more hawkish approach than that to which they were accustomed under the Yellen regime.

Then, Donald Trump reminded everyone that he had campaigned on the principle of protecting American jobs: he announced in February that he would be imposing tariffs on importers of steel and aluminum. Fears of trade wars and world wide depression spread around the globe.

And finally, during the investigation of Russian interference in the 2016 election, it became clear that Facebook had been very lax in protecting the privacy of its users’ personal information. The government called for explanations, threatened regulations and suddenly the whole business model of the social network — essentially selling profiles of users and likely customers to advertisers — was under bureaucratic siege.

Since five of the ten largest U.S. companies by market cap are directly or indirectly engaged in social networking and internet commerce (Apple, Microsoft, Facebook, Alphabet/Google and Amazon), one can see how distress in this segment could have an outsized effect on the market. The Wall Street Journal estimates that the above five companies accounted for 45% of the S&P 500’s year to date performance.

As long as these fears remain just fears, the current correction in the bull market will remain just that, a correction. The actual onset of a trade war or spiraling inflation and a subsequent explosion in interest rates would certainly trigger something much more ominous than a correction. For now, that does not appear likely: inflation remains relatively tame, the Fed seems committed to caution and the President continues to prefer exaggerated threats, as opposed to exaggerated actions, as tools for negotiating deals with our trading partners.

Despite correction concerns in the market, the reality of positive economic data continues to light up the daily news. Jobless claims maintain their downward trend. The ISM Manufacturing Index remains well above a neutral 50 (February’s score was 60.8). Consumer Confidence has been moving upward for at least two years and shows few signs of reversing direction. Housing Starts keep increasing. Durable Goods Orders have been growing at a healthy rate since July of 2015. And the Index of Leading Economic Indicators, despite a recently rocky stock market, is still exhibiting its best trend in the last seven years. Higher market volatility occurred in the first quarter, not because conditions or expectations changed from 2017 to 2018, but because uncertainty about those conditions and expectations increased.

It appears, as of this writing, that some of the uncertainty about the future has diminished. So far, the lowest point since the peak on January 26th was on February 8th — a decline of 10.2% in 13 days. After successfully testing that low on March 23rd, the S&P 500 is now down only 8.1% from its peak. Fears of a global trade war have diminished now that the President is back at the negotiating table with our partners. The concerns about new punitive regulations for the technology sector appear to have been overblown. Mark Zuckerberg of Facebook may have to sit in the Congressional bad chair and endure the indignant posturing of the political class, but the damage to the sector is likely to be minimal. Interest rates will definitely increase — the market has known about this for at least two years — but there’s no indication that the pace of increases or the target rates have changed dramatically.

We believe that the market will return to positive territory for the year — it’s currently down 1.2% year to date — as uncertainty diminishes. And the benefits of the tax cuts may very well be greater than the market anticipates, fueling a much more rapid growth rate than current valuations suggest.

We began this year with the concern that 2018 might not surpass or equal 2017 in market returns. That concern has been realized, for at least the first quarter. An obvious positive effect of a correction is that it provides a lower price point from which to grow; we would be very hesitant, however, about calling it a buying opportunity. Corrections have an unpredictable duration: since 1928, the average correction lasted four months, the longest one and one-half years and the shortest eighteen days. And then, there are those corrections that turn into bear markets. We’re not forecasting this for 2018 — there are too many positives on the horizon for us to be pessimists — but we must acknowledge the risk of the unpredictable, now and at all times in any market. But, for now, we remain optimistic.