Following an incredible year that enjoyed better than average market returns and remarkably low volatility, the market’s smooth ride turned rather chaotic during the first quarter. January began the year with an impressive gain, with the S&P 500 increasing 5.7%, which is the best January return in 21 years. Then a swift decline, that began in early February and extended into March, gave back all of January’s gains and more, ending the quarter with the market down –0.8%.
While there has been much speculation about the possible reasons for the market’s sudden swoon, we believe the start of the recent volatility was primarily the result of technical factors. In recent years, the level of market participation by investors has been increasingly overshadowed by computers whose trades are triggered by lightning-fast algorithms focused on market movements. During these volatile episodes, a sudden shift in the market can lead to an overwhelming number of orders from these machines, particularly on the downside, creating something like a vortex that can swiftly take stock prices lower.
A notable example of this type of market activity was the “flash crash” which occurred in 2010, and since then there have been several recurrences. Specifically, the recent decline bears a striking similarity to corrections that began in August of 2015 and January of 2016 (see above graph). In all three cases, the volatility seemed to come on very suddenly, and without a clear cause. As the chart above suggests, in these instances there is a sudden downward move, followed by many weeks of wild volatility before the markets settle back down. This suggests that we may experience further volatility in the near-term.
In recent weeks, President Trump surprised investors by announcing new tariffs on international trade, which further upset the market. The newly announced policies have created a fear that we may enter into a “trade war” with some of our international trading partners, China in particular. Most economist agree that if these trade restrictions are implemented, they could have a dampening (but not catastrophic) effect on the economy.
Despite the recent volatility in the market, the domestic and global economies remain strong and the outlook for a synchronized global expansion continues. U.S. GDP is expected to grow by 2.5%-3.0% this year and global GDP is expected to grow 3%-4%. Corporate profits, fueled in part by the recent tax law changes, are expected to grow by more than 10%.
Following last year’s gains, many were beginning to worry that the market was becoming dangerously overvalued. At the end of the year, the price/earnings ratio (P/E) for the S&P 500 was 18.2x, based on expected earnings. This was slightly above the historic average of 16.0x, so a little pricey, but not close to bubble territory. With the first quarter’s market declines and robust increases in expected corporate earnings, the current forward P/E is now 16.4x, which is much closer to the long-term average.
Federal Reserve Chairman Jerome Powell took over the top position from Janet Yellen in February. True to expectations, he increased the benchmark Fed Funds rate by 0.25%, raising it to 1.5%-1.75% at his first meeting as Chairman. The Fed is expected to raise rates 2-3 more times this year. As a result of the Fed’s actions, short-term interest rates have increased, making short-term financing more expensive for borrowers, and more profitable for lenders. To a lesser extent, longer-term rates have increased as well, pushing mortgage rates higher to an average of 4.4%, the highest in four years. Higher rates have also had a negative impact on bonds, as the Bloomberg Barclays Aggregate Bond Index declined –1.5% in the quarter.
Inflation concerns rose during the quarter and were initially identified as the cause for the sudden outbreak in market volatility. However, despite a tight labor market, the latest reading of inflation of 2.4% remains well below the long-term historic average of 4.1%. The expectation of higher inflation has also played a central role in rising interest rates.
Given the wild volatility so far this year, we feel it is likely that the volatility in the market could last for a while. However, we think the nine-year bull market still has room to continue. The global economy remains on firm footing and is positioned for further growth. Additionally, business friendly policies recently implemented by President Trump are likely to help corporate profits accelerate this year.
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Horizon Wealth Advisors is a Houston based fee-only wealth management firm. Horizon is a fiduciary advisor. We specialize in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.