After an especially profitable year for most investors, stock market volatility came thundering back in the first quarter of 2018. After peaking on January 26, the S&P 500 index fell 10.1 percent over two weeks, popped back up 8.2 percent over the following four weeks, and then continued to fluctuate dramatically. As of May 3rd, it was down a modest 1.6 percent of the year. S&P 500 volatility of this magnitude has not occurred for almost two years. The long period of quiescence led many investors to forget what market setbacks look like.
The relative calm of 2016 and 2017
While the Presidential election and Trump’s first year garnered headlines, investors worldwide were buoyed by three fundamental factors. First, economic growth was strong, often beating economists’ projections. Second, inflation remained tame, with many of its forward indicators undershooting expectations. Lastly, monetary policy remained steady with many central banks keeping short-term interest rates low. A common method of valuing financial assets is to discount future cash flows. Low rates engineered by central banks, which help keep discount rates low, combined with strong economic growth and corporate earnings, and lower than expected inflation, helped push up equity prices and kept volatility at bay.
What is behind higher 2018 volatility
Higher first quarter volatility was initially triggered by new government data released in February showing building inflationary pressures. This led to concern that central banks may be forced to push interest rates up faster than expected, which could mean higher investor discount rates and lower share prices. The growth outlook also became uncertain due to concerns about the threat of trade wars following President Trump's proposals for increases in tariffs on aluminum and steel. The prospect of higher interest rates also raised concerns that highly leveraged companies may have taken on more risk than they could handle. In the pithy words of Warren Buffett, “Only when the tide goes out do you discover who has been swimming naked.” For all these reasons, investors’ views on owning stocks became less rooted and equity markets became more volatile.
Getting used to volatility
Most investors understand that bonds are riskier than cash and that equities are riskier than bonds. But over long periods of time, the market tends to reward risk takers with higher returns. The willingness to endure volatility like what we had in the first quarter is essential to capturing the market returns available to long-term investors.
Dalya Inhaber, Ph.D., CFP ® is a financial advisor based in New York. She is the founder of Minerva Wealth Advisory, a Registered Investment Advisory firm. The mission of the company is to provide clients with tailored and unbiased financial planning and investment management. Dalya holds a Ph.D. in economics and statistics from the University of Michigan. The firm is named after Minerva - the Roman goddess of wisdom and knowledge. Minerva is often depicted with her sacred creature the owl, whose keen eyesight helps her navigate a path forward.