What’s Behind the Spike in Market Volatility?

What’s Behind the Spike in Market Volatility?

Equities continued their recent selloff, and the S&P 500 finished Thursday dropping just over 10% from its peak, hit on January 26. The decline of 10% makes the pullback an official correction. This leaves the S&P 500 down 3.5% year-to-date, which is a greater decline than the last major pullback that occurred early in 2016. At that time, stocks declined 6% due to investor anxieties about slowing growth in China. Now, investors are worried about too much growth.

The US economy is expanding at about 2.5%. S&P 500 earnings are coming in above expectations and should end the year increasing in the double digits. Revenue growth has also been strong. Unemployment stands at 4.1%, a 17-year low. Economic growth around the globe is also flourishing. Inflation is expected to remain between 2 and 3%.

So with economies expanding all over the world, interest rates, inflation, and unemployment low, why are investors nervous? Investors are nervous about too much of a good thing. Friday’s report on job growth was solid but showed a 3% jump in hourly earnings, fueling concern of rising inflation. Consequently, bond yields have risen which could raise borrowing costs and foster aggressive policy tightening. Even with the rise, interest rates remain well below historic norms and, historically, inflation has not been a major negative for stocks.

Since the 2016 pullback, the market has been on an extended rally, having gained 55%. Although S&P earnings growth has been solid, P/E ratios are still well above historic norms. Elevated P/E ratios may not be a good indicator of the direction of the market in the short term, but heightened awareness of its level increases anxiety, and fear is a quick motivator.

Pullbacks are not uncommon. Around the globe, stock declines of 10% or more have happened in two-thirds of the years since 1979. Corrections are a normal part of a well-functioning market; however, 2017 was one of the least volatile years on record. As a result of this stability investors have become complacent, which leaves the market vulnerable to volatility spikes. Emotions drive the markets in the short term and that’s impossible to quantify. Fundamentals only come into play over the long term. Currently, the economic backdrop is bullish for stocks and stocks are not cheap so they reflect that. No one knows what the market will do from here, but at this point, there is no reason to believe that the recent volatility is going to lead to a bear market.

 

Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

 

About The Author

Rick Cloutier, CFA is the Chief Investment Strategist for Washington Trust Bank with over 20 years of portfolio management and investment experience. Rick designs and implements investment and risk management strategies for the bank’s clients. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in the Journal of Investment Management and Financial Innovations, as well as, the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his MBA at Boston University.