Rising Volatility: How Concerned Should Investors Be?


Daniel McNeela, Mike Coop  |   09th Sep 2019  |   4 min read

Key Takeaways

  • Explaining market sentiment may be clear in hindsight, but difficult to forecast.
  • Predicting how macro issues will work out or how they’ll affect markets is next to impossible.
  • Volatility can be upsetting, but selling after significant losses can be counterproductive.
  • We believe valuations—not volatility—are the key to portfolio reallocations, although sometimes high volatility may open up a valuation-driven purchase.

 

Volatility returned in October, sending the equity market spiraling downward for a second time in 2018. Whenever this happens, investors naturally look for explanations for the downturn and wonder whether they’re in the right investments. We believe this response to volatility—although natural—is likely unhelpful.

Instead, investors are better served by putting recent market movements into the context of their long-term goals, in our opinion. For example, looking back a decade to the massive market decline of 2008, consider this question: Would an investor be closer to meeting their long-term financial goals by having sold out of equities after double-digit losses only to miss the rebound and one of the longest bull markets in history?

We believe discussing these types questions can be a much better reaction to market volatility than trying to understand every market move or selling to quiet fears.

 

Are the Good Old Days Over?

The good old days seem to be quickly sliding into the past. As recently as a year ago, markets were on a joyride. Ever-higher returns pushed painful memories of the global financial crisis further and further into the background. Even the U.S. market gained ground every month in 2017, delivering around 22% for the full year (in local currency terms).

The fear index, also known as the VIX or more formally the CBOE Volatility Index, rises during periods of market stress. But in 2017, the VIX couldn’t have been less scary, as it set record lows amid a seemingly ever-rising market. In fact, from January 1990 through December 2016, the VIX fell below 10 on nine days— nine days in 27 years!—but in 2017 it sat below 10 for 52 days so calm were the markets.

Volatility has clearly returned to markets in 2018. Earlier in the year, fears of rising interest rates and multiple trade conflicts set the market on edge. Investors continued to have confidence in leading growth stocks for much of the year until threats of stiffer regulations and the failure of a few internet darlings to live up to lofty expectations caused a dramatic rethinking of their worth.

If that weren’t enough, now investors can wrestle with slowing economic growth in China, the possible end of quantitative easing by the European Central Bank, and volatility caused by the U.S. midterm elections. If balancing all those risks to form a better forecast of how they’ll play out or affect markets seems like a tough job, we couldn’t agree more.

 

The Futility of Forecasting in Isolation

Clearly it’s hard to predict these issues in isolation. But in reality, these issues interact and evolve, and people react to them along the way, thus multiplying complexity and making outcome predictions next to impossible. We can’t know how today’s concerns might affect markets in the future. Take, for example, trade wars and tariffs, demonstrating how quickly investor sentiment can evolve.

Whether the market is—or will become—completely comfortable with the trade picture remains to be seen. Reaching a new North American trade agreement gave some relief, but progress has been elusive in talks with China—a situation that appears poised to potentially flare at any moment. But again, knowing when a flare-up might happen, how long it would last, and how it might impact markets strikes us as a monumental task.

We think there’s a better way to invest. Specifically, we don’t think every market hiccup needs deep analysis, nor do we believe in reading tea leaves. We prefer to focus our work on fundamental research, contrarian signals, and valuations. In the long term, investors get paid by the current and future cash flows of the securities they own. Being value investors, we seek to buy securities when prices are low compared to expected cash flows. This valuation work is the driver of our research, and it relieves us from becoming overly concerned about the next central bank rate decision or the outcome of an election.

 

So Should Your Clients React to the Spike in Volatility?

The short answer: No. The focus should always be on long-term valuations—the true and durable value of an asset class, rather than the volatility of its market price. Having a long-term perspective makes the next turn in the trade spat less concerning. Instead, we at Morningstar Investment Management ask, “How might this affect fundamentals over the next several years?”

Investors who trade on emotion and short-term market moves are more likely to sell after markets have gone down and buy after they’ve risen. We seek to do the opposite, in part by sticking to our principled approach to investing, which is designed to keep us rational in a sometimes-irrational world. In this regard, we are prepared to be buyers if and when valuations provide an attractive buying opportunity.

Originally posted 2018-11-26 10:48:42.

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