Review & Outlook

Our take on the investing, financial, & economic themes of the day

2016 Year-to-Date: Explaining Market Volatility

17 February, 2016 by Sally Sulcove, CFA, CFP in Commentary

Of the 30 trading days so far this year, half of them have had more than a 100-point swing in the Dow Jones Industrial average.  As grateful as we feel for the recent days of very strong, positive market action (such as the big gains logged today), it is human nature to feel more pain from the losses than joy from the gains.  It was the worst start to the year in a very long time; the Dow Jones Industrials index is down 7.0% year-to-date.  The VIX, a popular measure of implied volatility in the S&P 500 index options, is trading 65% higher than it was one year ago.  These are times that test investor’s nerves.

There is not one single answer driving investor concern.  Here is a list of commonly mentioned worries:

  • There is a great deal of concern about the economic situation in China.
  • The drop in the price of oil has investors worried on many levels.  The price of oil declined as supply increased, but now it seems that oil surpluses are increasing even faster due to a reduction in demand.  This has raised concerns that the drop in the price of oil is signaling a global slowdown and has increased worries about bankruptcies in the energy sector.
  • There are concerns for the durability and health of the US expansion, especially in the face of a rising dollar which makes American exports more expensive.  For example, Boeing’s airplanes now seem relatively expensive compared to those manufactured by Airbus.  When companies like Boeing face a decline in demand, it has ripple effects through the industrial economy.
  • Financial shares, which ended the year higher on hopes for a better earnings outlook after the Fed raised interest rates, have tumbled as investors have embraced lower interest rate expectations, especially after the Bank of Japan cut rates to negative territory on January 29.
  • Credit quality is also weighing on financial shares.   During earnings calls, many banks increased their loan loss reserves for the first time in years.  (Since the financial crisis, the ability to decrease reserves has helped bank earnings recover, making this increase a sea change.)
  • When oil prices were high, sovereign nation funds flooded the market with demand for equities.  Now these same oil producing nations are tapping their rainy day funds, not adding to them.
  • And there are ongoing worries of geopolitical risks, mistakes by policy makers, and the US presidential election.  A large amount of uncertainty creates a bad environment for stocks.

In life, as in the markets, when things seem down, we look for reasons and explanations.  Most of the causes listed above could be characterized as concerns more so than big fears—we have had plenty of those in recent years from the financial crisis to problems in Europe and especially in Greece.  Sometimes markets just need to go through a corrective process.  As the market was climbing to new highs in the first half of 2015, there was much market chatter about the stock market simply being overvalued relative to the earnings that companies produce.  This period since the financial crisis has been a long, albeit rather slow, bull market.

We are now nearing the end of earnings season, the time when corporations report their quarterly earnings.  Generally speaking, it was a weak earnings season, especially with the earnings from energy companies included.  It is likely to be the third quarter in a row of year-over-year earnings declines.  This has been the constant refrain in earnings reports:  slow global economy, strong US dollar, and problems in the energy sector.  There is a general feeling of greater uncertainty about the future as we listen to corporate conference calls.  Earnings estimates for the current and coming quarters have been trending down.  Fourth quarter earnings were not as bad as people feared.  About ninety percent of companies have reported fourth quarter earnings, and seventy percent of these companies reported earnings better than expected and roughly 50% have exceeded revenue targets, too.  Despite the overall direction of the market, the majority of companies performed reasonably well on the day that they released their corporate earnings, suggesting that as investors focus on results at individual companies they are more inclined to add to positions, despite ongoing macro worries.

How can investors best survive market volatility?  A willingness to stay invested through periods of market correction is just the entry test for investing in stocks.  Many of our clients have been with us for decades and have more than proven their fortitude!  Investors who do well during periods of volatility are those who have a long-term plan in place and stay focused.  Through the years, we’ve found that it is easier to stay the course when invested in high quality, well-known individual companies than it is to invest in more abstract market instruments.  Nestle, for example, is a concrete investment; the market may fall, but consumers will keep demanding chocolate, coffee, and pizza.  It also helps to stay focused on the cash that investments generate, which is why we have a preference for dividend-paying stocks at O’Brien Greene.  We also believe that bonds have a place in a portfolio, even at their current low-returns, simply because they provide ballast when the market tumbles.  Most of all, it helps to remember that the current trend won’t last forever.  (We do our best to remember this in good times and bad.)  We all have a bit of recency bias, the tendency to look to the recent past and expect more of the same.  History shows that those with a greater willingness to live with volatility have best outcomes in the long run.