The Return of Volatility is No Cause for Concern

by on Feb 14, 2018 Categories: us stock market

After a year of record low volatility in 2017, volatility has returned to the U.S. stock market. The S&P 500 index (the stock market “index”) increased 7.5% in the first 18 trading days of the year until reaching its peak level on January 26th. In only 9 trading days after the January 26th peak, the index had decreased 10.2% by February 8th. The index's 10% decline from its peak is what is commonly referred to as a correctionDeclines of greater than 10% are common occurrences with stocks (or any liquid asset class that has a degree of risk)Prior to this occurrence, there have been 27 market corrections since 1967. That would mean that corrections occur on average every 2 years. Of these 27 corrections, 18 ended before dropping more than 20% and falling into bear market territory  

It is important to reiterate that 10-20% declines are a common occurrence. In a climate such as this, many investors begin to wonder if this is the start of a bear market. My answer in this case is no. Historically, the stock market has not dropped more than 20% without being preceded by an inverted yield curve and subsequent recession. Currently there is no yield curve inversion to signal a recession, and economic GDP growth in the current quarter and looking out one quarter looks robust (at least 2.5% annualized). From a valuation perspective, the stock market is not severely overvalued. Currently the index P/E ratio is 24, which is in line with where it has historically traded. In fact, during the late 1990’s (1995-2000) when the index earnings were growing a robust 12-20% annually the index P/E ratio was consistently above 30 and spent significant time in the 35-50x range. As such, valuation is not going to be a particularly useful guide to tell the future direction of the market in the short term.   

U.S. stock market corrections defined as S&P index drops of greater than 10% but less than 20% are shown in the table below. These occurrences are significantly more (twice as) frequent and shorter in duration than bear markets (defined as index declines of greater than 20%). There are few if any preceding warning signs to stock market corrections, and I believe it is futile to attempt to avoid these as they are a normal function of investing in stocks (or any asset with a degree of risk)

My advice to any investor concerned about the stock market gyrations is not to worry and avoid closely following the short-term market fluctuations. Over the long-term (5+ years) the stock market, and subsequently your account value, will be higher than it is today. Unless you need to liquidate the stocks in your account within the next 1-2 years (in which case you should not be invested in stocks anyway), the daily, monthly or quarterly movements of the stock market are essentially meaninglessMarket corrections should be viewed as a buying opportunity. If you are a savvy person who has been holding excess cash, you should use declines to your advantage. By adding to your stock allocations during a correction, a buyer will be rewarded handsomely when it seems that everyone else is selling.