Over the past few days, the market has taken investors on a roller-coaster ride, and I suspect many of us are feeling a bit queasy. No one likes to be jerked down and up and back down again. What’s going on?
Putting things in perspective
As I write this, the S&P 500 is up more than 4.5 percent year-to-date, and the Nasdaq is doing slightly better than that. At the beginning of 2014, I predicted that the market would end the year around 1,850. Even after the drops, our current position isn’t bad at all.
On a year-to-year basis, we’re doing even better; the S&P 500 is up more than 14 percent from last October, much higher than average annual returns. And the pullback itself is just under 4.5 percent—actually quite small and something we’ve seen a couple of times this year already.
What’s more, over the past five years—a very good time for the markets from a return perspective—volatility has almost always been higher than it is now, as you can see in the following chart.
True, volatility is edging up. But it hasn’t hit the highs of 2014, remaining closer to the lows of 2009 through 2012.
From a historical perspective, then, the bumps we’re experiencing are very normal. From a return perspective, we’re still in a very good place. Even looking at the drawdown from the peak, there’s really nothing to be concerned about yet.
No gains without some risk
So, why the worry? Returning to the chart, you can see that the market has been incredibly calm over the past couple of years, and especially this year. Investors have come to expect that tranquility, which is a mistake. Financial markets are usually much more volatile than they have been, and that risk is at the heart of why we can make money there. You don’t get one without the other.
The question, of course, is whether the market will continue to drop. No one can say for sure. But here’s what we do know: Although prices move around, they ultimately depend on fundamentals, which are improving. Improvements in the economy should support the stock market, acting to limit any damage.
We’re in an interesting place right now. The economic recovery in the U.S. should drive markets up, but current values are already at very high levels—priced for perfection, really. In my opinion, this is what’s behind the rising volatility: the conflict between stocks being repriced to more reasonable levels, even as those reasonable levels rise with the improving economy. We should be seeing volatility here, as the market tries to sort out the reality of the situation.
Expect more volatility
We may quite possibly experience a further drop, even a significant one. Because of the improving fundamentals, though, we have something of a cushion below that will limit the damage, and possibly even set up a bounce-back.
Volatility is certain. Fortunately, we’re better positioned to weather it than we have been for years.
Disclosures: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s.
Authored by Brad McMillan, CFA®, CAIA, MAI, AIF®, chief investment officer, at Commonwealth Financial Network.
© 2014 Commonwealth Financial Network®