US losing streak sparks correction fears but volatility has not even started yet (if history is any guide)

Russ Mould
11 October 2018

“A five-day losing streak, capped by the worst one-day fall in America’s S&P 500 index since February, has investors asking themselves whether this is just the ‘healthy correction’ so beloved of market commentators or the beginning of something more serious,” says Russ Mould, AJ Bell Investment Director.

“While it is tempting to describe stock markets as volatile, they are really nothing of the sort, at least by the standards of the last 20 years.

“Even allowing for Wednesday’s nasty slide, the S&P 500 has moved by more than 1% from open to close on a daily basis just 34 times in 2018 to date. While that is an increase on 2016’s soporific count of just eight times, it leaves the US on track for its quietest year, using this benchmark, since 2006.

 
Source: Thomson Reuters Datastream

“And although Wednesday’s 3.3% feels frightening, it is only the tenth daily open-to-close movement this year of between 2% and 5%, that pales next to 55 such daily rises or falls during the crisis of 2007 and 2008, or even the 34 such intra-day gyrations of 2011, when US debt was downgraded and the Greek debt crisis began to simmer.

“The UK is similarly becalmed, looking at the FTSE 100 as benchmark, even if we have just had five straight days of open-to-close movements of at least 1%.

“That wobbly streak takes us to 42 daily rises or falls of more than 1% in the year to date. This is more than the 17 seen in the whole of 2017 but still leaves the FTSE 100 on track for its second-quietest year since 2005.

 
Source: Thomson Reuters Datastream

“One of the most startling features of the global equity markets (or at least developed ones) is just how calm have been this year. History (and the charts above) show this tends to be a good thing, as markets seem to do best during such periods of sustained calm, although there do seem to be four clear ‘cycles’ when it comes to market volatility

•    A period (often lengthy) of total calm, where headline indices do not gyrate, as they made steady, consistent upward progress

•    A period where the first doubts about the bull market creep in, sellers begin to challenge buyers with their force of their opinions and headline benchmarks make progress but at a lesser rate and with greater effort. Ultimately, this proves too much for nervy buyers and holders, who crack and start to sell.

•    A period where doubts finally give way to panic. Volatility becomes the norm as share prices and indices gyrate wildly, but with a clear downward bias. Finally, the wet towels come slopping into the ring as buyers capitulate and turn seller at almost any price.

•    Markets bottom amid this final frenzy. Calm descends as buyers begin to regather their nerve as they find assets that are once more attractively valued, and markets begin their next march higher.

“It is not hard to work out where we are now, in the first of four phases. The question now is whether we are about to start moving through the gears, as we did from 1997 to 2000 and then 2005 to 2007, as calm gave way to doubts, nerves and then panic.

“The good news therefore is that low volatility has tended to be good for equity returns, as shown by 1995 to 1998 and 2003 to 2005, for example.

“Nor does rising volatility stop markets, as 1998 to 1999 and 2005 to 2006 suggest.

“But low volatility could be bad news, too. The charts above also suggest that unusual calm leads to unusual risk-taking which leads to over-exuberance, poor capital allocation and eventually volatility’s return with a vengeance as poor (or simply over-valued) investments falter and confidence finally cracks – even if we all know the past is no guarantee for the future.

“The question now is whether we are about to start moving through the gears, as we did from 1997 to 2000 and then 2005 to 2007, as calm gave way to doubts, nerves and then panic.

“Peripheral arenas, such as cryptocurrencies, low-volatility strategies and emerging markets have already buckled, and maybe this volatility is now moving towards core, developed asset classes.

“It is an interesting coincidence that this is happening as the Federal Reserve has raised interest rates and begun to withdraw the stimulus (and liquidity) provided by Quantitative Easing, the European Central Bank has begun to throttle back on QE, Japan has perhaps begun to reassess its monetary policy and the Bank of England has begun to raise interest rates too.

“If Japan starts to taper QE then another source of cheap cash will start to dry up, especially as the ECB plans to stop adding to its QE plan in December. That could have far-reaching implications, when how growth in the assets of the world’s five leading QE proponents is compared to global share prices over the past decade. 

“Liquidity has goosed global share prices (and valuations across a whole range of assets from stocks to bonds to art to wine to cars to property) so there has to be a danger that its withdrawal has the opposite effect.”

 
Source: Thomson Reuters Datastream, Bank of England, Bank of Japan, European Central Bank, FRED – St. Louis Federal Reserve Database, Swiss National Bank

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