Volatility is Back
The past couple days have tested investors’ appetite for risk with a spike in market volatility which we haven’t seen since June 2016. The Chicago Board Options Exchange Volatility Index (VIX), a measure of market downside volatility, has spiked gaining 28.51% on Friday, February 2nd and 115.60% on Monday February 5th. Making the headlines are what’s on the other side of volatility; VelocityShares Daily Inverse VIX ETN (XIV) and the ProShares Short VIX ETF (SVXY), trading strategies that bet on rising but calm markets. Both trading strategies lost more than 80% of their value as volatility surged. These headlines create an opportunity for us to once again highlight the differences between these shorter-term trading products versus what Covington does, which is to invest long-term in proven enterprises. Our strategy has created attractive returns for our clients by owning good companies over long periods of time. A recent article on CNBCoffers a stern warning against these trading products as “destroying the best capital market in the world”.
But first, what happened?
We believe we are at a watershed moment in this economic cycle. Economic fundamentals are attractive and corporate earnings remain strong, as a result we are starting to see an uptick in inflation. More specifically, on Friday, the January jobs report was published showing wage growth accelerating 2.9% over the last year, the strongest year-over-year gain since June 2009, according to the Labor Department. As a result, bond yields pushed higher in anticipation of a more aggressive Federal Reserve raising short-term interest rates.
So, do we think the bull market is over?
Not likely. We do believe that we are in the late stages of a bull market and pull backs or corrections are perfectly normal at this stage of the market cycle. The underlying fundamentals of the economy are still intact with GDP growth picking up, a full employment picture, tax reform, and a “low but rising” inflation picture. We also continue to see growth in corporate earnings as measured by the S&P 500 12 Month Operating Earnings which are up as of December 31, 2017, 4.70% quarter over quarter and up 17% for the year with 69% of companies reported. This economic growth cycle has not yet peaked.
Conclusion
We expect volatility to remain elevated throughout 2018 as we go through an adjustment period, especially compared to 2017. We are closely monitoring the actions of the Federal Reserve and tone of future expectations. Rising rates are a good sign of a healthy economy, but we don’t want an aggressive Fed that raises rates too quickly. We are also monitoring the impact of the Fed’s balance sheet normalization. Again, adding to the likelihood of continued volatility in 2018.
Now is a good time to re-evaluate your risk tolerance and make adjustments as necessary. For investors with a long-term horizon, volatility and corrections may create opportunities to buy. When we have corrections like what we have recently experienced, it’s important for us to reinforce our investment strategy. At Covington, our approach continues to be to build portfolios that help each client meet their financial goals whether it’s a focus on income generation or capital appreciation or both. We feel that by putting the focus on your long-term goals we won’t let volatility like we have recently seen cloud our judgement and make costly investment decisions. This means that we like to invest in a diversified way by taking a conservative approach with a focus on high-quality, proven enterprises that pay dividends and have solid balance sheets that are not overleveraged.
Past performance is no indication of future results.