Market Update - Volatility Has Returned

The equity market environment has undoubtedly changed.  Prior to the volatility the markets have experienced starting Friday, February the 2nd, we were setting records for the length of a bull market with low volatility.  We were seeing the one of the best starts to the year for stocks until something changed, so what was it?

There are a variety of opinions of course but several experts were predicting that the 10 year treasury yield would end the year at 2.9% and after just over a month of market adjustments, the 10 year yield has risen from 2.5% to 2.8%, which may have the effect of putting pressure on the equity markets.  Certainly the move has taken the experts by surprise and that may have been the genesis of the this market dislocation.  In short, the market may be preparing for an increase in inflation.

Even if inflation and the quick move in 10 year rates were the cause, there has already been several add-on effects that have magnified the slump and increased the volatility.  First, speculative investments that volatility was going to remain low almost literally blew up on Monday the 5th (you can search "XIV" to learn more).  This only added concerns to the market.  Secondly, whenever volatility spikes some market participants begin to sell positions due in part to the higher volatility, such as having a stop-loss.  The extra selling pressure only exacerbates the decline.  Normally this is a knee-jerk reaction that is quickly absorbed by the investors who have been waiting for a pullback to invest.  However, in some cases it isn't arrested quite so quickly.  It's rather remarkable as well that the stock market really hasn't been in decline for more than a week and the main indices, Dow Jones Industrial Average and S&P 500, are down roughly 10% from the market peak.  That is an incredibly fast decline and usually the faster the decline the quicker the recovery.

The question that remains, however, is even if we get a quick recovery does this mean we're in a new era and the 2017 market of low volatility is gone?  I think it is and that 2018 will not be a repeat of the very positive performance the stock market generated for 2017.  For long-term investors there is no need to make changes to your investments. No doubt the market is still expensive but investing is for the long-term and market movements of less than a week are very short-term. Preparing your portfolio for an inflationary environment, however, seems to be an appropriate consideration, if indeed the market correction is the result of a coming increase in inflation.

On the positive side, the economy remains strong and still heating up, earnings for companies should continue to grow, but history proves that the stock market and the economy are not as correlated as you may think and the Federal Reserve increasing interest rates has more of an impact on the stock market than the health of the economy, especially in light of the extraordinary policies that resulted from the 2008 financial recession.  The time to take caution for a long-term investor is when both the economy and the market are faltering.  If both of these indicators are problematic  that is often when the longer lasting recessions occur.  So far this looks to be a "normal" correction.  Unfortunately, they often start off that way and this time the domestic stock market is quite expensive compared to its historical metrics and comparable international markets.