Stranger Things: An Unprecedented Period of Low Volatility Will Run Its Course

 In Strategy Updates

The rise of stock prices, coupled with the lack of market volatility, in the past 12 months has been wonderful. We hope you have enjoyed it as much as we have! However, it is unprecedented. Global equity indexes have not experienced a decline of more than 4% for more than 14 months in a row. Never in history has there been such a long period of low volatility. This is truly one of the “stranger things” that we have witnessed in our almost 25 years of managing financial assets as a firm and in my 35 years as a professional investor. Is this the new normal? Have we entered a new era? Sadly, we do not think it is possible.

It’s not that months of low volatility and rising stock prices are uncommon, it’s just that this one is much longer than most. When we revisit similar periods of low volatility paired with advancing stock prices, there appears to be some common ingredients. Almost always low volatility and rising stocks come with an environment of better than expected economic and profit growth, underinvested institutional and individual investors (high cash balances) and some type of outside stimulus that make stocks the most sought after investment alternative. Historically, these phenomena have been most common during periods of economic and profit improvement – think 1985, 2003 and 2009. When we consider the financial circumstances of the past 14 months, this all fits neatly into place. We have certainly experienced a significant recovery in global economic and profit growth, which caught the over worried and underinvested public and private investor by surprise. Pile on the significant pro-growth fiscal policy, such as tax cuts, and you get the makings of a huge demand for stock exposure. The mere concept of trillions in currencies chasing a fixed number of publicly traded stocks makes for higher stock prices with low volatility – the Holy Grail!

This cozy and profitable environment will eventually end – and we don’t dare predict when so as not to spoil its longevity. However, investors would be wise to prepare for a return to a more normal stock market. Still profitable – but not as cozy. There is enough economic and profit growth momentum for stocks to continue upward – and we believe for quite some time. Global stock prices based on earnings (Price/Earnings Ratios) are not excessive at 18.3 and the “E” continues to grow at a great clip, with the help of fiscal stimulus. This should keep the P/E reasonable as equity prices rise. What this market will be missing going forward are the over worried and underinvested public and private investors. They are no longer underinvested or as worried. Over the past 14 months every dip in stock prices was met with piles of cash itching to get more fully invested, preventing normal stock market corrections. Now that those cash levels have been depleted, we can expect business as usual. As global stock markets grind higher, we will likely see very normal 8-10% corrections along the way.

Whenever we get our first real correction in stock prices we should be prepared. The numbers can be a bit unsettling when the Dow Jones Industrial Average is above 26,000 (it was 700 when I started in the business!). A simple and normal market correction of 8-10% would be the equivalent of 2000-2600 points! Don’t let the absolute numbers mess with your brain or emotions – try to keep your wits and look at your portfolio and the market in terms of percentages.

For the fixed income investor, the higher interest rates that have come with the stronger economy and profit cycle are a blessing. We expect the Federal Reserve to continue raising rates this year which will make our purchase of bonds even more attractive. This is not a time to own bond funds or bond exchange traded funds. These products perform very poorly as rates rise, which investors are just starting to experience. We only invest in individual bonds, which will benefit us well as rates continue higher.

As you know we are optimistic in regard to our outlook, however should circumstances change or get “stranger” in a bad way, we will be managing the risk of your portfolio through your allocation to stocks, sector management and the use of carefully placed stop loss orders. All of these tools are intended to manage normal volatility, but mitigate catastrophic loss.

We hope you find these thoughts helpful. If you have questions, would like to review your portfolio or have experienced a significant change in your financial circumstances please let us know. As always, if you have any friends or colleagues who you feel may benefit from our services, we would be happy to introduce ourselves to them with a no-obligation introductory meeting.

Once again, thank you for your vote of confidence in our work.

Your Team at Main Street Research