Volatility wakes up with a jolt.
Market volatility’s long nap ended abruptly in early February with 150% more days recording Standard & Poor’s 500 index movements of more than +/- 1% than in all of 2017. And although we saw the pattern of positive stock returns end, too, the S&P 500 finished the month up for the year.
Early February marked the end of a long period of unusually low volatility in stock markets. Last month saw 12 days in which U.S. large-cap stocks (as measured by the S&P 500 index) moved by more than +/- 1%. Seven of these days were positive and five negative (including three big down days early in the month). By contrast, all of 2017 had only eight +/- 1% days. February also broke the pattern of positive stock returns as by Feb. 9, stocks at home and abroad were down sharply. While stocks recouped some of their losses during the rest of February, they still ended the month down. Large-cap stocks were down 3.69% for the month. Mid- and small-cap stocks were also down 4.43% and 3.87% respectively (S&P 400 and 600 indices).
International stocks fared slightly worse than domestic stocks. Developed markets fell 4.51% (MSCI EAFE Index) and emerging markets dropped 4.61% (MSCI Emerging Markets Index). Interest rates rose over the month, leading to a fall in bond prices with the Bloomberg Barclays Aggregate index down 0.95%.
Looking at last month’s market declines from a slightly longer perspective, the S&P 500 is still up for the year with a positive return of 1.83%. Developed-market stocks also are positive for the year, with the MSCI EAFE Index up 0.28%. Bonds, however, are down 2.09% since Jan. 1.
Why it happened.
It’s impossible to say precisely why market volatility kicked up early in the month. Explanations include the indirect effect of relatively obscure financial instruments that bet on market volatility, and worries that continued strong economic performance might lead the Federal Reserve (Fed) to raise interest rates faster than expected.
It may be more useful to look at some of the actual concrete events in February. First, earnings season (the period in which companies report their results for the previous quarter) closed strongly. Over the season, 77% of S&P 500 firms reported higher sales than analysts expected (FactSet). Second, wages grew more than anticipated. Together, these point to a strong economy, which is a good thing. Why, then, did markets appear to react negatively?
Higher wage growth increases fears that inflation may rise, which in turn could lead the Fed to raise interest rates to prevent the economy from overheating. We also have a new Fed chair, Jerome Powell, and it’s not yet clear how “hawkish” or inclined to raise rates he is. Trying to get a read on him, market participants paid close attention to his House testimony near the end of the month. After he spoke, stock markets fell and interest rates rose, suggesting he is viewed as somewhat more hawkish on inflation than his predecessor, Janet Yellen. By the end of February, the yield on 10-year bonds (the interest rate that the government needs to pay to borrow for that period) had risen to 2.87% from 2.72% at the end of January. One-month yields rose from 1.43% to 1.5%. These increases reflect expectations of future interest rates.
Looking overseas, foreign stocks faced a headwind as the dollar rose by 1.71% (measured by the DXY Index). This is a change in direction from a long decline that’s lasted since December 2016. A stronger dollar hurts the returns of foreign assets for U.S. investors.
What it means for you.
After a long period of smooth sailing, the sudden return of market volatility may be unnerving. It’s important, however, to stay focused on your goals and put recent events into a longer-term perspective. We discuss how to cope with volatility in this month’s sidebar. Your portfolio probably will have declined this month, since all major asset classes fell. Bonds, however, fell by less than stocks, and lower-risk portfolios allocate more to bonds. This means the closer you are to retirement or the lower your risk preference, the less your portfolio will probably have fallen.
If you decided to take more risk or are a long way from retirement, your portfolio will have a greater allocation to stocks. Stocks offer greater expected returns over a long horizon, and so your portfolio will likely have fallen more this month. At Financial Engines, we build portfolios to meet your unique situation and preferences. If you have concerns about the level of risk you’re taking, we encourage you to call one of our advisors. We’re here to help.