Peak to trough in 2018, the S&P 500 has now fallen greater than 10 percent, the amount commonly defined as a correction, in less than two weeks. There hasn’t been even a five percent drop since mid-2016, so this decline is a real jolt to the complacency that the low-volatility rally instilled in many investors. A subtle change in the macroeconomic picture likely set the correction in motion, but the sharpness of the decline appears to have been exacerbated by excessive risk-taking in the corner of the financial markets home to volatility instruments.
The addition of fiscal stimulus via tax cuts to a market already accustomed to steady growth, low inflation and low interest rates created an unsustainably rapid equity rally through January 2018. However, the increased likelihood of higher inflation that accompanies higher economic growth prompted a steep rise in longer-term interest rates, and January’s strong employment report was further evidence calling into question the assumption that monetary policy would stay reliably easy.
As a result of the Goldilocks environment described above, some investors speculated on financial instruments betting on low volatility, which became a very crowded trade with outsize underlying risk. The sudden unwind of these bets, including the failure of at least one of those instruments, may have pushed volatility measures (notably, the CBOE Volatility Index, or VIX) artificially high, magnifying the perceived level of risk in the market and prompting further selling.
The recent moves have already shown signs of a climactic event, according to our research partners. If so, that would mean the market is likely to be in for some choppy trading sessions, but with less force and volatility. We intend to stick with our strategies either way. Looking out a bit further, the high-return, very-low-volatility days may well be behind us. That being said, macro and corporate fundaments still look quite healthy and at least moderately favorable for stock prices, barring a surprisingly strong tightening of monetary policy or some other exogenous event.
Martin C. McWilliams III, CFA®
AVP, Associate Portfolio Manager
David M. Kirkpatrick, CFP®
SVP, Portfolio Manager
Charles A. Williams, CFP®,CTFA®
SVP, Portfolio Manager
Brian A. Barker, CFP®, AIF®
SVP, Director of Asset Management