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Volatility Returns

Market volatility has been near historic lows for the past two years, but now it’s back. Here’s why.

For the past two years, market volatility has been unusually low. One measure of stock market volatility has been running at nearly half its normal level. But this year, that’s changing. 

Stocks soared the first few weeks of the year, only to fall recently. Currency and bond markets have been much more volatile as well. An index of Treasury market volatility has jumped 26% in the past three weeks. The benchmark 10-year Treasury yield reached 2.84% on Friday, the highest level in four years. 

While I remain bullish, I am unconvinced that the recent pause in the stock market rally is complete. I think the odds of a garden variety correction—a drop of about 10%—are rising.

Why now, when the economy is so strong and earnings are mostly very positive? There are three main factors I believe have caused the shift: 

  1. Interest rates are higher and likely to keep rising. Bond yields are responding to higher inflation risks (and bond prices move inversely to yields). A jump in yields could be negative for stocks, which are valued in part based on their growth prospects compared to a risk-free Treasury rate. The weaker U.S. dollar is part of this story (See my post from last week, “Worrying About a Weaker Dollar”).
  2. Economic strength, which ultimately translates to earnings growth, may have reached peak levels. Already some recent regional economic reports and manufacturing surveys have been a bit more mixed. Tax reform effects, a positive for earnings and economic momentum, are likely to fade.
  3. Stress from Washington, which investors have mostly been ignoring, could be a source of volatility. Congress still needs to finalize the budget and raise the debt ceiling. Meantime, higher Treasury yields are driving up the cost of financing government debt. The fact that the nation’s $20 trillion in debt is now 100% of GDP is unlikely to go unnoticed by investors.

Bottom line: I don’t think the bull market has ended, but the odds of a correction are rising. I think the S&P 500 could end the year at 2750 – near where it is now, but I expect that there will be some ups and downs between then. 

To manage rising volatility, I have been recommending investors diversify their holdings across sectors, asset classes and regions and also turn to actively managed portfolios, as opposed to index funds. Investors who want to minimize the impact of market volatility on their overall portfolio may want to add a fund that can take both long and short positions, potentially benefiting whether the broader market rises or falls.

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