Broker Check

Volatility Never Feels Normal

| September 28, 2022
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Stock market volatility has resurfaced, and it bears significance to gauge its source and its potential for sustained downside. We’re living in a short-term era of ambiguity that is exacerbated by the anticipated actions of the Federal Reserve, Russian aggression against Ukraine, and an upcoming earnings season that has a lot of hype to live up to. To top it all off, the recent mild volatility is the first of its kind since March 2020. In fact, it’s the first of its kind (in a long time) that has not been generated from a direct and tangible event-driven threat (such as COVID). It’s important to make that distinction clear because investors often carry a misconception that volatility is always associated with something bad, or that perhaps volatility is foreshadowing a riskier event in the very near future. Or often times investors have the idea that volatility must carry a direct and specific reason to surface. The reality is often much less exciting, yet this is one of the most difficult concepts to attempt to provide investors clarity on. Let us attempt to break things down.

The initial takeaway that must be understood in the market today is that we cannot associate the volatility of the S&P 500 (as a standalone index) to be equivalent to –or a gauge of—aggregate global equity market health. That’s simply not true. The S&P 500 suffers from a top-heavy weighting bias to the largest companies in the U.S., many of which fall in a growth-oriented segment that remains largely embedded in the technology sector. As of Monday, January 24th, the S&P 500 has posted a total loss of approximately -7.50% (including dividends). Its value-oriented counterpart remains at -3% while the growth index remains near -11.50%. This is a tremendous discrepancy that becomes critical in assessing portfolio management allocation decisions and overall risk management. For those investors in tune with the volatile swings this year, you will notice that overvalued growth stocks appear to be the main culprit of recent volatility, which provides for an objective and appropriate volatility cycle. What’s also encouraging is that international equities, both developed and emerging, are performing exceptionally well relative to U.S. markets. It remains difficult to gauge the path of such a trend, but we remain committed to the benefits that a globally diversified equity portfolio can provide portfolios.

The second takeaway needs to be rooted in understanding monetary policy actions, or rather, the anticipation of Federal Reserve interest rate hikes as early as March 16th, 2022. Current market implied probabilities indicate a 95.9% chance of a rate hike in March. Conventional wisdom is quick to suggest that rising interest rates by the Fed will be the death of the bull market, hence the reasoning for the volatility year-to-date, yet we’re hard-pressed to substantiate that statement with data. Chart 1 provides a true representation of what has occurred to the S&P 500 during the previous 12 Federal Reserve tightening cycles (since the 1950s). Except for the 1972-1974 cycle, which happened to coincide with a U.S. recession, the return profile of the S&P 500 has generated positive annualized returns during the observed tightening cycles. Although it may seem like an eternity ago, our most recent experience with a tightening cycle occurred just four years ago (2015-2018) in what transpired to be a thriving time for consumer consumption, economic growth, labor market gains, and overall sustained sentiment and retail fiscal health. What this means is that the real purpose behind the likelihood of a rise in interest rates is because the economy can sustain it. We have voiced our analysis in the recent past where we have indicated the need for tighter monetary policy well in advance of the current timeframe for reasons mainly tied to a fiscally healthy consumer. We may now be nearing that threshold. Be that as it may, it’s important to note one additional data point in this analysis. Although Chart 1 remains positive, the S&P 500 return data in the 2-3 months post an initial interest rate hike tends to produce marginal volatility that can often be blamed directly on The Fed’s actions. What this may mean is that U.S. markets may sustain volatility through the first half of the year (assuming an interest rate hike in March 2022 occurs) before gaining a decisive trend in mid-to-late summer. This also suggests that we’re anticipating, and are proactively positioning ourselves for, potential equity market opportunities leading into Summer 2022.

On the topic of Russian aggression against Ukraine as a catalyst to U.S. equity market volatility, we would urge caution in arriving at that conclusion. There is no evidence to suggest a link between the two events, and if the tension escalates, it is likely to remain a regional geopolitical event. It’s possible that certain global commodity assets may be impacted in the short-term, but the risk to systematic downside from other factors remains absent in our view.

Our last takeaway in this volatility centric commentary is simply focused on the notion that volatility never needs an immediate and direct catalyst for it to occur. This is hard to accept, yet it’s reality. Our tendency to trigger internal biases during short-term volatility prompts emotions that need to often carry a reasoning for why something is happening. When tangible reasoning is missing, that’s when we often take inappropriate action, such as the tendency to want to exit equity market participation. We urge investors to remain vigilant, objective, and focused beyond the immediate short-term. Those that are open and willing, to study and pinpoint counterarguments to their steadfast opinions are often the most successful investors.

Edison Byzyka, CFA – Chief Investment Officer – Credent Wealth Management

9/28/2022 Commentary

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Investment advice offered through CX Institutional, a registered investment advisor.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted.

All return data sourced from Bloomberg. All other data soured from Bloomberg, through the release of monthly figures from the Department of Labor, Bureau of Economic/Labor Statistics, U.S. Census Bureau, or from the Federal Reserve and any of its affiliated regional locations. Small Business Optimism sourced through NFIB. Small business hiring plans sourced through NFIB. Consumer sentiment sourced through the University of Michigan. Earnings data sourced through Bloomberg Intelligence and through Bloomberg’ earnings analysis composites.  Interest rate cut/rise probabilities are sourced from Bloomberg’s tracking of futures contracts tied to the Federal Funds interest rate.

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