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Market Volatility Makes a Comeback

July 3, 2018

For investors, 2017 was an unusually calm year. The S&P 500 stock index never changed by 2% in a single day, either up or down. There were only eight 1% days all year.

2018 is shaping up to be a very different story. CNNMoneyInvest reports that in the first quarter we’ve already had six 2% days and 23 1% days. Should this pace continue through the year, we’ll have the most volatile year for stock prices since 2008.

Two economic factors may be contributing to these wild swings. The U.S. economy is at, or nearly at, full employment. Labor shortages have appeared in some parts of the country, raising questions about how much more economic growth we may expect. As important, by some measures stocks have become expensive compared to their earnings. We might be approaching a market top. This is an environment that investors have not seen before, and they seem uncertain about which way to jump. Will the federal tax cuts result in a surge of economic growth, making this a good time to increase equity exposure? Or will external factors—perhaps a breakdown in international trade, or a new foreign conflict—trigger a selloff? No one can know for certain.

The way to calm volatility in an investment portfolio is by diversifying among asset classes—adding more bonds, for example. The bond markets also can be volatile, but at times stock and bond prices move in opposite directions. Having a well-diversified portfolio may bring steadier investment returns.

Historical context

Stock prices have been buoyed by a surge of investor optimism, coupled with improved earnings and the economic boost from tax reform. The price/earnings ratio is a measure of how relatively expensive stock prices have become. Economist Robert Shiller has developed the CAPE ratio, a cyclically adjusted P/E measure that also takes inflation into account and smooths the results over a ten-year period. The graph below shows the recent movement of the CAPE ratio and the interest rates during the period.

 As you can see, the stock market as a whole is at historical highs by this measure. For some investors, that may suggest that the upside in stocks already has been captured, so that the future risks in equities are more important than the low interest rates of today’s bonds. High stock prices may make bonds more attractive.

Finally, the current economic expansion is almost ten years old. Some may see the high CAPE ratios as harbingers of an overdue contraction.

© 2018 M.A. Co. All rights reserved.

Interest rates and the CAPE ratio chart

 

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