The recent surge in stock market volatility is a sharp reminder that calm market conditions can change with little warning.
ANATOMY OF A CORRECTION
Market corrections are a natural part of investing, but such downturns can unnerve investors because they fear the sell-off could signal something bigger — the beginning of a longer, deeper bear market. So, what distinguishes a market correction from a bear market?
After a long hibernation, volatility returned with a vengeance to equity markets in early February. Prior to this resurgence, the market experienced the longest run in its history without a five percent correction. That period included a strong run since the 2016 election that generated a 37.5% total return through the market peak on January 26th, including a surge in prices that saw the S&P 500 jump nearly 200 points in January alone.1
In early February, that surge quickly reversed with the S&P 500 entering official correction territory with the close on February 8th, dropping -10.2% from January 26th, including big declines on February 5th and 8th of -4.1% and - 3.75% respectively. The February 5th decline was accompanied by a single-day surge in the VIX Index of 20 points from 17.3% to 37.3%. That was the biggest one day jump in the VIX since its inception in January 1990 and a sharp contrast to the 11.3% average from election day 2016 through the January 26, 2018 peak in the market. On the other hand, the -4.1% daily drop in S&P 500 on February 5th barely made the top 50 since the end of 1945, coming in at a rank of 49.
Stocks & Volatility: What goes up…
S&P 500 and VIX: 11/8/2016 – 2/5/2018
Source: Bloomberg, as of 2/5/18. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
What sparked the market downturn?
Market corrections are a normal part of investing, but it has been two years since we have had one -- so the recent drop may feel particularly painful. Many market observers have argued that it was long overdue.
Corrections occur when investor optimism pushes prices too far ahead of underlying fundamentals, which leads to profit taking that in turn can stoke broader panic-selling that pushes prices even lower. However, there’s usually a catalyst that breaches the complacency that existed prior to the recession.
Presently, investors seem concerned that we have moved from a “Goldilocks” not-too-hot and not-too-cold economic environment to one that could overheat from fiscal stimulus and push inflation higher, which in turn could lead the Federal Reserve (Fed) to raise interest rates faster, effectively slamming the brakes on growth.
Economic fundamentals look solid
Yet just as investors can naturally become too complacent when the market is setting new record highs every other day, it’s also normal human behavior for them to overreact when markets turn violently downward. While it’s still too early to tell when the current sell-off will stop and how far prices will ultimately fall there are numerous indicators that suggest the economic fundamentals are in place to support further gains in equities when the correction settles.
- U.S. and global growth is positive
- Corporate earnings growth in the U.S. is continuing
- Consumer spending is supported by low unemployment and potentially stronger wage growth
Of course, there are risks to consider even when economic fundamentals are positive. Even with the drawdown that has occurred so far, equity valuations remain generally elevated, Fed policy could shift from its current course and geo-political risks still merit watching, including potential changes in U.S. trade policy.
Investment implications: Things to remember
Market corrections can be healthy for both the market and investors, allowing an opportunity to consolidate recent gains and prevent a more serious situatio