Volatility is back – time to buy the dip?
Market commentary by Clément Gignac
Last year was one of the least volatile on record for the equity markets, and we predicted the calm would not last much longer.
After a roaring start to the year, which saw January rank among the best starts ever for the S&P 500 Index, volatility has reappeared with a bang. We believe the pullback is clearly tied to the synchronized jump in interest rates, with U.S. tax reform quickly priced into inflation expectations. It’s likely also a result of heavy ETF trading activity.
Many indicators were pointing towards short-term vulnerability in the markets: the 14% gap between the level of the S&P 500 Index and its 200-day moving average, and the fact that we had just recorded the longest stretch without a 3% drawdown since 1950, at 448 days (see table below), to name only two. As is common during corrections, we quickly shifted to a “stock market” instead of a “market of stocks,” leaving few places to hide.
S&P 500 performance following extended periods (200 + days) without a 3% pullback (1928-2018)
|Index returns after trough|
|Peak dates||Number of days without a 3% drawdown||Worst drawdown 10 to 15 days after peak||1 month||3 months||6 months|
Data as at February 5, 2018.
What to do now?
We remain firmly in the camp that this is a buying opportunity for our funds, since we see a prolonged business cycle. None of the fundamentals have changed, and we believe this pullback simply gives us a good entry point. Also, it is worth noting that historically, when the VIX index jumps to current levels, the expected return over the next two-to-three months is firmly in positive territory (see table below).
|%||S&P 500||Russell 2000|
|When VIX > 20||Return||Annualized||Return||Annualized|
|Subsequent 2 months||4.6||30.6||5.2||35.7|
|Subsequent 3 months||6.4||28.1||7.8||34.9|
|When VIX > 25|
|Subsequent 2 months||4.8||32.6||5.0||34.3|
|Subsequent 3 months||6.9||30.5||7.9||35.6|
Note: 2010 to present
Source: Standard & Poor's, Russell, CBOE, Haver Analytics, Credit Suisse
A short-term correction of 10% or more is completely normal. Historically, this happens, on average, every nine months (the last one came in early 2016).
We also know from market history that a bear market, which is defined as a drop of 20% or more from the most recent peak, coincides with recessions, and our economic dashboard is still flashing green. In fact, historically, we have rarely seen a bear market starting when the S&P 500 Index is at or below its long-term trend, as it remains currently despite recent hefty valuations.
The result is that the S&P 500 Index went from a frothy 18.5× forward earnings in late January to a more reasonable 16.7× as of February 6. And as equities were hit pretty much everywhere across the globe, we find ourselves with much more attractive pricing everywhere. For example, the S&P/TSX Composite Index is trading at 14.7× forward earnings – the same level as in early 2016, when the world feared a recession. In a nutshell, whatever markets you liked in late January, you should now love in February.
Our view is that the synchronized global growth story remains well anchored; inflation should be climbing slowly from here on; and the Fed will likely hike rates three or four times before the end of the year. So, our macro view has not changed and we still expect to end the year with positive returns on equities and the 10-year rate above 3% in the U.S.
As we have warned for some time, a healthy return of volatility should remain a major theme in 2018, favouring an active management style.
- Business cycle – The upward and downward movement of gross domestic product over time. The business cycle has four main stages: expansion, peak, contraction and trough.
- Drawdown – Refers to a decline in value of a market or security.
- Exchange traded fund (ETF) – A security that trades openly on a stock exchange and represents an underlying basket of securities (frequently an index). The price of an ETF is determined by supply and demand on the stock exchange, and not (as with mutual funds) by daily net asset value.
- Forward earnings – A company’s projected or expected earnings.
- Valuation – A measurement of how much an investment is worth. It is determined by analyzing a variety of factors, including financial statements and industry statistics.
- VIX – Also known as the “fear gauge,” the VIX is the most commonly referenced measure of market volatility.
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