First Quarter 2018 Investment Commentary
Volatility returned to the financial markets in the first quarter, for the first time in a while. Global equity investors had a particularly bumpy ride—an experience we’d suggest getting used to for the months and years ahead. Stocks surged out of the gates in January, with larger-cap U.S. stocks up nearly 8 percent at the market high on January 26 (Vanguard 500 Index). This was followed by a short but sharp market correction, which dropped the market 10 percent over the next nine trading days. The VIX volatility index had its biggest one-day move ever, spiking more than 100 percent on February 5. U.S. stocks then rebounded into mid-March, clawing back much of their losses, before dipping again into quarter-end, buffeted by fears of a potential trade war with China (and possibly some U.S. allies as well) and a Facebook data scandal. When the dust settled, large caps ended down 0.8 percent for the quarter.
Developed international stocks also got off to a strong start to the year, before suffering similar losses to U.S. stocks during the sharp correction in early February (Vanguard FTSE Developed Markets ETF). They made up ground relative to U.S. stocks in March and ended the quarter down 1 percent. Emerging-market stocks held true to their higher-volatility reputation, shooting up 11 percent to start the year, falling 12 percent during the mid-quarter correction, and then once again outgaining U.S. and international stocks to finish the quarter with a 2.5 percent return (Vanguard FTSE Emerging Markets ETF).
Core bonds didn’t play their typical “safe-haven” role in the first quarter. They posted losses during the sharp stock market correction in February and delivered a 1.5 percent loss for the quarter overall, as Treasury yields rose across the maturity curve (Vanguard Total Bond Market Index). Our absolute-return-oriented and actively managed fixed-income funds outperformed the core bond index for the period.
The Return of Stock Market Volatility (aka Stocks Can Go Down as Well as Up)
- The 10 percent market correction was short-lived, but it provided a reality check for equity investors.
- However, the U.S. economy and wider global economy still look solid in the near term.
- Looking ahead, we have positioned our portfolios for further volatility and likely lower equity returns as the markets ride out what is already a longer-than-usual economic cycle.
In our 2017 year-end commentary, we noted that by some measures U.S. stock market volatility was the lowest it had ever been in 90 years of market history. Of course, most experienced investors knew that was unsustainable. We also knew the exact timing, magnitude, and catalyst of a market disruption couldn’t be predicted with any precision. We highlighted central bank policy tightening as a potential or likely trigger, along with the ever-popular and all-purpose “unexpected geopolitical shock.”
As it turned out, the catalyst was an economic data point in early February showing higher-than-expected U.S. wage inflation. It unnerved markets to think that overall inflation may be rising more rapidly, thereby suggesting the Federal Reserve would tighten policy (raise interest rates) more aggressively than the consensus had been expecting. Selling then begat more selling, as short-term traders (the speculative herd) rushed to unwind their misplaced bets that the very low market volatility regime would continue.
Although the 10 percent market correction proved to be very short-lived, it may still have provided a nice reality check for some investors in terms of testing their true risk tolerance. Stock market corrections of 10 percent or more in any given year are very normal. Historically, they’ve happened more than half the time. (A 5 percent decline has happened in more than 90 percent of years.) We think this is a reasonable expectation for the future as well. That is why stocks are called “risky assets.” In exchange for their higher long-term expected returns, you must be willing and able to ride through their inevitable periods of decline.
The Best Defense
As we reflect on the volatility levels we have witnessed so far, this year, it’s worth reiterating why we emphasize a five-year or longer time horizon as the basis for our expected-returns analysis. It is over those longer-term periods that valuation (i.e., what you pay for an investment relative to its future cash flows) is the most important predictor of returns. Over the shorter term, markets are driven by innumerable and often random factors (i.e., noise) that are impossible to consistently predict (although that doesn’t stop lots of people from trying).
There are a lot of paths financial markets and the economy can take to reach our base case scenario destination. And there is a wide range of reasonably likely outcomes around that base case. Simply put: markets and economies are unpredictable. But when it comes to the investment world, we are often our own worst enemy. We fall prey to performance-chasing, our natural inclination to “do something,” and other behaviors that may have helped our ancestors but hurt us as investors. The best defense is a sound, fundamentally grounded investment process like ours that you can have confidence in and stick with for the long term.
—OJM Investment Team