Volatility's Bite Returns: What Now?

By Ginger Szala

April 02, 2018 at 03:28 PM

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On Feb. 5, 2018, the S&P 500 stock market index fell 113 points, or 4.10%, to 2,648.94, while the VIX index that tracks changes in underlying market moves jumped to a stunning 37.32, up a historic 116%. That same day, the Dow Jones Industrial Average crashed 1,175 points to hit 24,345.75.

This woke up most market watchers, made more than a few traders weep with joy and shook up many investors. The 17 investment experts and advisors who shared their views with Investment Advisor, though, had this sober take on the development: The "new" volatility is normal, and the smooth sailing investors have been experiencing over the past year or so is not normal. In other words, don't panic.

"Today's volatility is normal per past periods — except for the past two years," said Brad McMillan, chief investment officer of Commonwealth Financial. "We have gotten used to a much calmer environment recently, which has created a false expectation that the market really is calm. In fact, what we are seeing now is much more normal than 2017 was — and we better get used to it."

In fact, 2017 didn't see a drop of more than 3% for the entire year, notes Andrew Crowell, vice chairman of D.A. Davidson. "We went 404 days without a drop of 5%. This is highly unusual," he said, adding that for the eight years since the end of 2009, the S&P 500 increased 138% (not including dividends), or 11.4% annually.

During that same eight-year period, the S&P 500 index dropped by at least 5% on 14 separate occasions. "Each time, however, the bull market remained intact, and the market ultimately went to new highs," he explained.

Plus, since 1980, the largest annual pullback experienced in each year has averaged -14.9%. "Even in bull market years, it is normal to have an 8-12% pullback within the year," said Mike Gibbs, director of equity portfolio and technical strategy for Raymond James. "The recent 2018 pullback was sharp — but within the normal range — as the S&P 500 contracted -11.8% in 10 days from its peak to intraday low."

Randy Rae, manager of investment strategy and research for the wealth management firm Aspiriant, agrees this year's volatility isn't different, although the move was "unusually swift." He adds that it's "healthy for the markets."

This "new" volatility shouldn't surprise investors. But given that many market fundamentals are still sound, why did it emerge?

A Bumpy Start to 2018 The Volatility Index, or VIX, which measures the implied volatility of the S&P 500 index, jumped 116% on Feb. 5 while the S&P 500 index plunged more than 4%. Volatility was picking up before the spike, and has remained active since.

Source: CBOE

"It's driven more by secondary factors than direct recession risk," said John Lynch, executive vice president and chief investment strategist of LPL Financial. These include a new Federal Reserve chair, a "modestly hawkish" Fed member-ship as well as those who agree with a lighter touch on regulation, a long "unprecedented" period of extraordinarily low volatility, and mid-term elections in the wings, he says.

Long-term periods of low volatility "eventually make the market more sensitive to catalysts," and mid-term election years "tend to be more volatile," according to Lynch. "Throw in recent policy risks around trade as a kicker," he explained.

Still, the Dr. Jekyll and Mr. Hyde action by the VIX certainly should cause pause, notes Grant Jaffarian, portfolio man-ager at Crabel Capital Management, LLC.

"The existence of two completely different volatility scenarios, all within about a six-week stretch, makes it hard to argue against market volatility looking somewhat 'different' than it has in the past. The 'why' is difficult to answer with certainty," Jaffarian said. Still, he believes there are several post-2008 factors that are commonly overlooked.

First, "There has been a constant and deep flow of assets into products that end up operating in similar ways," the portfolio manager explained. At least four broad categories of investments "have theoretically hastened a volatility reduction across global markets," he says.

Examples of strategies that could operate as "volatility dampening" inflows include beta products that target market returns like the S&P 500; alternative-beta vehicles that target market inefficiencies in a rules-based fashion, such as value equity investing; risk-parity oriented investments that aim to frequently rebalance for several market "beta" returns like equity risk, fixed income, etc.; and trend-following funds that target momentum across several asset classes.

"While fairly different in posture, all these vehicles can exhibit very similar characteristics in low-volatility environments," Jaffarian said. "As volatility declines and long-term trends extend, as it has been seen in the case of equity indices, exposures slowly rise to big volatility targets and/or as a function of inflows." This action "remains true, theoretically, until it doesn't, at which point redemptions, volatility adjusting and unwinding could create the opposite effect," he added.

Second, before 2008, bank proprietary trading desks provided a big chunk of market liquidity. Post 2008, that mantle — like it or not — often has been taken up by high frequency traders. "They do not play with house money, but their own money," Jaffarian said. As such, if the market environment does not suit their trading, they may widen spreads or even chose to sit on the sidelines for "a couple minutes or hours," which can further exaggerate market swings.

Due to these two factors, advisors and investors should be ready for "longer stretches of collapsing volatility followed by shorter and yet far more severe bursts of volatility," Jaffarian says.

Rising volatility is one of Pinnacle Advisor Solutions "themes" for 2018, according to Chief Investment Officer Rick Vollaro. The only "real wrinkle" of the February correction was that some investors got caught up in the unwinding of a trade that was betting on continued low volatility, he says.

"The speed of the correction makes this feel different," Vollaro explained. "But that probably is due to the combination of the overbought state of the market prior to the correction, the volatility unwinds and computer programs that tend to amplify moves in either direction." (See "The VIX & Other Fear Gauges")

Aging Market Cycle? Most, but not all, portfolio experts and advisors who spoke with IA agree that we are in a late stage of the current market cycle — maybe.

"It's an odd cycle," LPL's Lynch said. "Margins, employment, Fed tightening and the start of higher inflation point to a late cycle, and that's where we are big picture. But coordinated global growth and earnings reacceleration off of the crash in oil put us closer to mid [cycle]. Fiscal stimulus, which is completely out of joint for this point in the cycle, points to an early [cycle]. Call it a late cycle, but it's not a normal late cycle."

Other managers concur. "It's not easy for fundamental investors to understand where we're at in this cycle," said Dan McNeela, senior portfolio manager and co-head of target risk strategies at Morningstar Investment Management. "To do so is always murky, but extremely low interest rates have muddied the water."

Brad Thompson, chief investment strategist of Frost Investment Advisors, explained, "We are in an early late cycle but a recession is not imminent."

This late-stage bull market and business cycle seem to have legs, according to some investment experts. For example, though he believes we are in a mid-to-late bullish cycle, Probabilities Fund Management CEO Joe Childrey sees the market in the middle of a longer-term bull run "as the market climbs the wall of worry."

"There are always 'this time is different' events and potential black swans, so a correction or bear market could hap-pen anytime," he explained. "But as far as valuations, business cycle and employment numbers, the market looks good. We might get some competition from the bond market when 10-year Treasuries reach 5-6%, but we are not even close to those yet."

Big Moves Through Century

Feb. 5, 2018 may have been the largest drop point-wise in the history of the S&P 500, but it doesn't even hit the top 10 big moves by percent. Black Friday still ranks as the largest drop of the S&P 500 in its history, falling 20.47%. However, the two other eras that ranked most volatile were the Great Depression starting in 1929, and the Financial Crisis of 2008.

Source: Standard & Poor's

High growth rates and tight capacity will stimulate inflationary pressures and interest rates, Vollaro says. Plus, the late-cycle fiscal stimulus that is expected "should give the economy a jolt and may intensify inflationary tendencies that are already building in the system," he explains. "We believe the markets are wrestling with the dynamics of this economy in transition."

One force behind this stimulus is tax reform, which has changed the game and economic outlook, according to C.J. MacDonald, senior vice president and portfolio manager at Westwood Wealth. Before tax reform, "We were in the late stages of a normal business cycle with a small amount of market upside to go. However, the tax law changes were so significant to both consumers' pocketbooks and Corporate America's bottom lines that we look for the economy to show strong numbers again this year," he explained.

2018 Expectations Expect more of the same volatility we've experienced in the first couple months of 2018, many experts say, particularly because the market has returned to "normal" volatility. Rae defines "normal" as the stock market dipping 5% or more at least a couple times during the year and the VIX remaining higher than in 2017.

No doubt, market participants will be "on edge and will be trying to divine the next big shift with each significant economic data point, earnings release, or Fed statement," explains Cliff Stanton, chief investment officer of 361 Capital. "As such, we expect 2018 to be far more volatile than 2017 and much more in keeping with historical equity vola-tility patterns."

Market activity in the first six weeks of 2018 is "a likely predictor of continued volatility for the balance of the year," according to Crowell. This means more market spikes, as well as profit taking that could add to volatility.

The new tariffs President Donald Trump imposed should add to the increased volatility, says John Toohey, head of equities for USAA: "We expect higher volatility due to burgeoning signs of inflation, a Federal Reserve that will likely be less accommodative, and an overhang of potential tariffs on trade that could end the long period of globalization and the economic stability that came with it."

Keeping an eye on the VIX Index is imperative for both advisors and investors, some managers point out. For example, one reasonable scenario is there is "a general decline in volatility back to a less than 10 VIX within the next quarter that is sustained till the end of the year," Jaffarian says.

"We expect a return to normal historical levels during 2018," Alfred Eskandar, co-founder of Salt Financial explained. "Investors can bet on the VIX hitting 20, and not returning to 10 this year."

Several factors likely will come together to normalize volatility, with a frequency of greater than 1% daily moves, says Frost's Thompson. These factors include Fed interest rate hikes, the lagging effect from the changing shape of the yield curve, the quantitative tightening regime, peak profits, corporate taxes now incorporated into earnings, higher expectations, the new risks brought on by trade policy, and investors who expect capital spending to raise productivity.

However, "[If] capital spending increases pipeline inflation pressures in the supply chain, this could add to inflationary pressure, adding to the risk the Fed 'kills' the cycle," Thompson said. One adage is particularly relevant today:

Cycles do not die of old age, they are killed off by the Fed — or some shock like the bursting of a bubble (as in 2000 and 2007) or some external shock, he adds.

As higher volatility is predicted to be the norm for the year ahead, how will it be different from 2017? The speed at which information is shared and processed by market participants is, of course, on the rise.

"This is a positive because it gets hashed out more quickly," said Brandon Moss, director of XY Investment Solutions. "Our biggest concern is the emotional connection people have to 1,000-point drops, which causes them to make much more susceptible rash decisions." He sees valuation being replaced by momentum and the fear of missing out (or FOMO), "which gets away from real intrinsic valuations. Very reminiscent of the tech bubble."

Gibbs agrees: "Given the reliance on systematic trading platforms, periods of sharp volatility are a high probability for a long time. However, we do not feel every period of weakness will be exacerbated by systematic trading to the degree seen during the January to February pullback." Instead, he sees pullbacks of 3-5% being the norm for the near term.

Playing Defense With continued higher volatility expected, different portfolio strategies will be needed to take advantage of market moves or protect investments from cannibalization of gains. Definitely, "long-term investors should not sell solely because of volatility," says Morningstar's McNeela. "Often the best thing to do is to do nothing, and that's typically the case with volatile markets."

That said, he believes defensive positions should be taken by underweighting U.S. stocks, U.S. government bonds and cash. "We also think value-oriented sectors in foreign developed and emerging markets are relatively attractive compared to U.S. stocks," the portfolio manager explained.

Its longer-term view of "entrenched growth" and "stuckflation" means Northern Trust Asset Management sees a "con-structive backdrop for risk assets," according to Darek Wojnar, head of funds and managed account solutions.

"During the recent market correction, we asked ourselves if that narrative still held. Because we thought it did, we maintained our overweight [stance] to risk assets — global equity, high yield and real assets such as real estate — and in some cases, used the market weakness to get underinvested portfolios to target allocations," Wojnar explained.

Crowell agrees. "It is quite possible — and in fact probable — that the strong market gains of the past nine years have caused meaningful deviations from target allocations levels. Investors should rebalance to their targets on a regular basis to ensure compliance with their plan," he said. "Don't forget, diversification is critical."

Diversification and sticking to long-term plans are the most prevalent advice passed on by advisors, portfolio managers and investment strategists. "Don't panic and stick to your plan," said LPL's Lynch.

"Despite rising rates, in the big picture we think bonds can still play their traditional role as diversifiers. Keep near to slightly above benchmark risk but look for traditional 'higher vol' sectors — such as small caps, emerging markets — to provide excess risk-adjusted returns."

"For true diversification, we lean on our risk-control assets — including cash, inflation-linked fixed income and investment grade fixed income," said Northern Trust's Wojnar.

Also, dividend-growth strategies "tend to perform well in the latter half of economic cycles," according to USAA's Toohey.

Frost's Thompson suggests investors examine higher quality floating-rate debt to hedge rates and credit risk. He also believes investors should look at strategies with a lower correlation to the conventional balanced (60/40) set up and equities that grow "relatively independent of the cycle." Finally, "consider positioning your fixed-income duration shorter," adds Tooney.

The view of 361 Capitals' Stanton is that investors should be "dialing back equity risk, increasing cash to be put to work at better valuations in the future and embracing strategies that can truncate losses (for example, long/short equity) or derive returns that are uncorrelated to equities, like managed futures," he says. Although Thompson agrees with the idea that investors should consider increasing their holdings of alternative investments, he prefers hedged or private debt rather than private equity.

Probabilities' Childrey says his new portfolio mix is 50/30/20, with the 20% being alternatives. "This new mix is intending to mitigate potential Fed moves that drive bonds lower," he said. "With the broad range of liquid alternative investments available to retail investors today, the idea merits consideration due to the risk/reward characteristics of such a strategy observed over a long term."

Tactics are as important as strategies, investment managers insist. Lynch suggests using tax loss harvesting to rotate to preferred asset classes. "Dips may provide opportunities to add modestly to risk, but that's a more challenging route," he said. For his part, Morningstar's McNeela cautions against "a 'buying the dips' strategy that doesn't carefully consider valuation."

Yet buying dips strategically is smart, note some advisors. According to Gibbs, "As pullbacks occur, investors should take advantage of the weakness to make tactical decisions within the confines of each client's long-term investment plan."

Other experts suggest dollar cost averaging, which McMillan says "remains useful in a volatile market." Crowell goes along with this view: "Use market volatility as an opportunity to dollar cost average for new cash or even rebalancing."

Many advisors welcome the volatility. "Volatility can be the investors' friend," Vollaro said.

Salt Financial's Eksandar sees its upside for advisors, who "must harness its power to drive returns instead of shunting it aside as something to fear and use rebalancing to enforce discipline." He recommends combining highly volatility assets with "staid" ones to create acceptable variances in portfolios and to provide a future cushion. "Taking risks should pay off," Eksandar explained.

Not Their First Rodeo Many advisors and investment professionals have been through this type of volatility before, such as during the 2006-2007 stock run up, says XY's Moss. "After such a large run-up, many clients became what we would call 'overfunded' based on their goal set and had some good options. Either take on loftier goals or reduce allocations and take some volatility out of their portfolios," he explained.

Commonwealth's McMillan compares today's volatility to that of 1999. "When clients start to reach for risk and fear missing out more than anything else, they usually learn that is a mistaken attitude," he said. Investors tend to ask about relative value — specifically the relationship between corporate credit and equity volatility — too late in the cycle, according to Matt Rowe, managing partner and chief investment officer of Headwater Solutions.

"This was particularly so in 2008, which saw an unprecedented spike in volatility — of over eight standard deviations [in the VIX] — and a collapse in the corporate credit market," he said. "The current likelihood of repricing in corporate credit and equity is high, based on historical measures and [expectations regarding the market] landscape going forward."

The financial crisis taught many a lesson, says D.A. Davidson's Crowell. "The sharp market correction which accompanied the Great Recession is quite instructive," he said, adding that some long-term clients couldn't ride out the market storms.

"Some even questioned whether their financial plan was relevant and should be believed, as this type of black swan event was perceived to be completely new and untested…," Crowell explained. "Some never reentered the markets as they just didn't trust the recovery."

Market battle experience has its benefits, Jaffarian points out, as those without it seemed very shaken by the Feb. 5 explosion of volatility. "They could not fathom how fast and meaningfully equities were correcting," he said. "For the vast majority of investment professionals who have worked through at least one, if not several far more severe and long corrections (2008, 2001 and 1987), the week of Feb. 5 felt perhaps more like a return to normality than a severe earth-shaking event."

Toohey recalls the Brexit vote of June 2016 and the associated bout of volatility, which he saw as an "opportunity to focus on fundamentals and valuation and to stick to the investment process."

MacDonald also has a long-term perspective. "The market was recently at an all-time high," he explained.

"What that means to us is that for every recession we have ever had — every depression, world war, Watergate scandal, or energy crisis — we have survived it and gone on to new highs. 100% of time," the portfolio manager said. "The only thing that can derail a long-term investment plan is to abandon it when times look tough. Stick with an intelligent wealth-management plan, and turn off CNBC."

Ginger Szala is executive managing editor of Investment Advisor and the former editor-in-chief of Futures Magazine Group.

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