Ask the Investor: “This week the stock market has been a rollercoaster, should investors be worried?”By: Ryan T. Fulmer
Sunday, February 11, 2018
The stock market has been a rollercoaster ride with the Dow Jones reflecting several declines of 1,000 points with surges to positive in the same day!
Our firm invests in individual stocks and bonds for the long-term. Whenever we meet with a new client, we discuss the importance of taking a long-term approach to planning and investing. The week of February 5 has been a great example of how uncertainty and emotion can derail your long-term goals.
Why has the stock market been so wild this week?
Over the last few years, the stock market has appreciated from improving earnings and also rising price-to-earnings multiple (P/E). Investor’s willingness to pay for a stream of net income is closely related to interest rates. As interest rates fall, price-to-earnings multiples move higher; and as you might have guessed after this week, as interest rates move higher, the P/E multiples tend to drop.
Over the last few months, economic data relating to inflation has started to move higher as the economy shifted to full employment while tax cuts spurred activity. Subsequently, ten year U.S. Treasury bond yields have hit a 4-year high of 2.88%. In December it was widely accepted by the stock market that the Federal Reserve would increase the Fed Funds rates three times in 2018. Recent inflation data has moved investors’ expectations toward four interest rate hikes in 2018 and perhaps much more in future years.
Part of the erratic movements in the stock market recently has been due to these facts. Part of the explanation also relates to a favorite hedge fund style concerning volatility or how much stock prices change on any given day.
Since the recovery of the great recession, volatility has been incredibly low. Hedge funds have bet against rising volatility through shorting a specific volatility index called the VIX. This approach worked very well, and the amount invested in this strategy grew to about $300 billion. Like anything else, Wall Street created additional vehicles to mimic this approach through exchange-traded funds (ETFs), and exchange-traded notes (ETNs). This period of low volatility ended abruptly, and several of these products almost went to zero on Tuesday and Thursday.
What should investors be watching?
At this point, the stock market decline seems to be just a correction. During the wild swings in the stock market, other asset classes such as corporate bonds, interest rates, and foreign currencies, have moved slightly, but not in a magnitude that is indicative of a liquidity crunch, or recession. This trend could change, but so far so good.
We are also watching the volume of shares traded on many of the ETFs and ETNs that relate to the troublesome VIX index. A few of these ticker symbols are UVXY, VXX, TVIX, and SVXY. The number of shares traded on Thursday was easily 3-5x the average volume and in some cases 3 times more shares traded than Apple’s stock.
At this point, we expect the stock market to stabilize in the next few weeks and then gradually recover due mostly to the improving economy. In many parts of the world (including the U.S.) economic growth has accelerated considerably and should provide a tailwind for the stock market. Nervous investors should meet with their investment manager and discuss the asset allocation of their portfolio, as well as, the types of companies you might own (growth, income, e.g.,). If you are a retiree, a good rule of thumb is to have the percentage of cash and bonds in your portfolio to be at least several years of annual withdrawals.
It can be challenging to be a long-term investor, so stay rational.
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