Volatility Returns and That’s Ok!

“Variety is the spice of life”. So goes the old proverb taken from a poem written by English poet William Cowper in 1785. We’ve all likely heard the quote, though I’ll admit to having no knowledge of its origin until I looked it up for this newsletter. Regardless, the passage has certainly stood the test of time. In many ways, we can all relate to it through countless personal experiences and anecdotes.

Personally, as someone who relishes  routine and predictability – an odd set of characteristics for a guy who chose a career analyzing the inherent unpredictability of the markets – I can also relate to needing variety to keep life interesting.  My kids remind me of this fact every day! So, too, does the stock market.

The Role of Volatility in Market Dynamics

The U.S. stock market has enjoyed a period of relative calm since the middle of 2023. It wasn’t until a few short weeks ago that calm was materially interrupted due to some soft economic data and less-than-perfect earnings from high-flying tech companies. When volatility hit, it hit swiftly as investors flocked to the exits. However, despite its dramatic return, volatility isn’t always bad. In fact, it’s a normal, dare I say healthy, part of the market. To describe this better, let’s take a look at volatility throughout recent history.

The best way to measure volatility in the stock market is through a measure called the VIX index. At its core, the VIX is designed to tell us when there are a lot more sellers of stocks than buyers as the index only shoots higher when stocks fall a lot in a short period of time. Below we can see how the VIX has skipped around over the last 20 years.

As we can see, the recent bout of volatility certainly registered as higher than average given how little volatility there was in the preceding 12 months. However, the average volatility of the S&P 500 going back 20 years is roughly 19. Currently, we’re sitting just under the average, which suggests we’re returning to a more “normal” level of market volatility.

Why Volatility Can Be a Healthy Market Indicator

Some may think this volatility is unhealthy for the market as it can cause stocks to misprice due to individuals selling based on fear. While this may make some sense on the surface, we see this kind of volatility as healthy for the stock market in the long term.

Often, when there’s a lack of volatility in the stock market, participants have the tendency to become complacent. When this happens, we often find stock prices exceed valuations that can be justified by earnings or other qualitative factors. People become less cautious, take more risks, and invest more than they have, which ultimately drives prices higher than a rational investor may otherwise accept as a good price. We believe this is what has been happening since the end of October 2023.

Once volatility returns to the market, especially if it coincides with economic data that suggests the economy is slowing, investors can panic when rational thought returns and assumptions are revisited in light of a less-than-perfect outlook.  When this happens, we find that the market becomes better calibrated to obvious risks and enables individuals who want to invest in the market to do so under more reasonable valuations.

While U.S. stocks have recovered much of their losses from this period of volatility, we still believe valuations remain higher than we’d like to see. On the other hand, we don’t find the recent jobs reports to be terribly unsettling either. Our outlook remains neutral with a slight negative bias on U.S. stocks as a result of current large-cap valuations. However, we believe this area of the global market remains the strongest of the lot.

Volatility is a natural part of the market. Occasionally it rears its head in grandiose fashion as it did at the beginning of August. Most times it comes in smaller waves. Regardless of how volatility arrives, we should view it for what it is; a healthy evolution of the market, especially if you’re a long-term investor!