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In recent days, we have witnessed large swings in the price of major global stock indices

Feb 2018

Our thoughts on recent Stock Market volatility

In recent days, we have witnessed large swings in the price of major global stock indices.  These larger than normal price moves have occurred after an extended period of strong market performance and low price volatility, as exhibited in the chart below.   

Naturally, this raises both questions and concerns about the outlook ahead.  In this note, we offer our perspective.

What is causing the volatility?

We see multiple contributing factors at play.  In particular:

 

  • On February 2nd, employment statistics for January were reported.  The headline job numbers were strong, with the economy adding an estimated 200,000 jobs.  The unemployment rate remained low at 4.1%. However, investors focused more on the modest rise in wage pressures – something broadly absent from the labor market for some time.   This stoked concern that higher wage inflation might signal a return of broader market inflation, causing bond yields to rise and stocks to fall.
  • Many large investors had positioned portfolios to profit if market volatility remained low, as it has for years.   As volatility rapidly spiked – investors rushed to unwind their losing “low-volatility” positions, further pressuring stocks.   This factor was largely technical, rather than fundamental.   But it was the primary reason for a -4.1% drop in the S&P 500 index on the following Monday – the largest percentage drop since the U.S. lost its AAA credit rating in 2011.  
  • There is a new Chair heading the Federal Reserve board, as Jerome Powell replaces Janet Yellen.  We don’t know yet whether he might be inclined to raise interest rates faster if inflation indicators rise further in the coming months.

 

 

What has (or has not) changed?

 

  • While we expect volatility to remain elevated, the basic view which we outlined in our most recent Economic & Market Commentary has not changed. Fundamentally, we expect the U.S. economy to grow close to 3% percent in 2018, with a boost from fiscal stimulus and tax reform.  We expect incoming Fed Chair Jerome Powell to raise interest rates at least three times, reflecting confidence in economic growth. These factors should support higher stock prices over the coming year.
  • While wage pressures may be increasing, market based measures of inflation remained relatively subdued, and we expect a gradual rise in inflation rather than a sudden spike.
  • What about corporate earnings?  With about 75% of companies reporting for the most recent quarter, earnings are up 22% over last year.   68% of companies reported higher than expected sales revenue, while 76% reported higher than expected net earnings.  This is the best earnings season since 2012, and that is reflected in stock prices. The key to sustainably higher prices will be continued earnings growth as the year progresses.
  • The final factor we watch closely is valuation – which is the multiple that investors are paying for an expected future stream of earnings and dividends. Right now that multiple is about 17.1x 2018 expected earnings.   This is about a 6% percent premium over the 25 year historical average of 16.1x. So while valuations are modestly high by historical measures, we do not see an enormous “bubble” in stock prices as we have in prior market peaks.

 

What are we doing?

  • The current bull market run in U.S. stocks dates back to March of 2009.  That is close to the longest expansion on record. As stocks have advanced, we have routinely pared back larger positions and rebalanced portfolios towards broad asset allocation targets.  This is an important component of active portfolio management, and part of our investment discipline.
  • Most portfolios own a mix of assets – including cash, bonds, and equities.  It is important that we are aware of your defined cash needs over the next 18 to 24 months so we can reserve ample liquidity.  This prevents us from having to sell equities to meet distribution needs.
  • Assess your risk tolerance.  If you feel like you are taking more risk than you are comfortable with, perhaps some adjustments are necessary.  Conversely, if you have a long term horizon, you may be inclined to add to stock positions which have cheapened in price.  The important thing is to assess your objectives and communicate with us. As always, we are here to help guide these conversations.
  • Avoid being overly swayed by media reports.   The financial press devotes enormous attention to daily market moves, which can play to people’s fear (as well as greed).   Often, these reports are little more than “noise.” A better approach is to set a long-term strategy and stick to it, paying less attention to daily fluctuations.

In closing, we welcome your questions and concerns.   As always, we appreciate the trust and confidence you place in Howland Capital, and look forward to working together to achieve your investment goals.

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