April 27, 2017
April 27, 2017
A salient characteristic of the current market environment is the unusual relationship between the level of global economic uncertainty (high) and the level of market volatility (low). As a general rule, investors prefer more stable investments such as bonds and cash during periods of high uncertainty. Consequently, periods of high uncertainty are typically characterized by periods of high stock market volatility (bigger daily swings in the major indices) and, often, declining stock prices.
The current period is an exception to the rule. The level of global economic policy uncertainty is quite high as measured by an index created by professors at Stanford and the University of Chicago. At the same time, stock volatility is quite low. In fact, the S&P 500 had only one daily drop of more than 1% during the entire first quarter. This is highly unusual.
What might explain this unusual environment of high global economic uncertainty and low stock market volatility? And what are the implications for investors? These are important questions to consider since the implications for near-term stock returns are very different depending upon the cause of the divergence.
An optimistic interpretation is that investors are appropriately filtering out much of the uncertainty and focusing instead on the relatively healthy underlying economic fundamentals – for example, corporate profits are expected to continue growing and the job market is firm. This interpretation, if correct, suggests that stocks should continue trending higher unless a monumental shock such as the breakup of the European Union occurs, and further suggests that, absent such a dramatic event, investors should continue focusing on the generally positive underlying economic fundamentals.
A more pessimistic read is that investors are becoming overly complacent to the risks in the market. Over the past year, two major events, Brexit and the election of Trump, have turned out to be false alarms for investors since predictions of big market declines accompanying these developments were off-the-mark. Given this recent experience, investors may have started believing that the stock market is impervious to policy surprises. This interpretation, if correct, suggests that the stock market is vulnerable to a decline. If investors are complacent to the risks, a return to more normal levels of volatility could rattle unsuspecting investors, leading to increased stock sales and downward pressure on prices.
There’s likely some truth in both explanations. Investors are generally well-served by focusing on the underlying fundamentals rather than the twists and turns of policy developments and, as noted, the current fundamentals are reasonably solid. At the same time, the level of complacency among investors seems high. In this environment, it is especially important to maintain a disciplined investment approach. With history as a guide, stock market volatility is unlikely to remain at the current low levels for much longer.