Markets sailed through the past two years with relatively little instability, but volatility has risen recently. As we move ahead in 2018, we think investors face a choppier ride, and with volatility spending most of the past two years near historic lows, we recommend a proactive approach to position for – and potentially benefit from – bigger swings in the market.
Before February, it had been more than 20 months since the last 5% selloff, the last 10% correction was over two years ago, and the VIX index, which measures market volatility, had reached the lowest level on record.1 These are hardly bad things – particularly since this tranquility was accompanied by double-digit average returns from Canadian, U.S. and overseas stock markets over the past two years.* But, the recent pullback and sharp swings in stock prices remind us that low volatility: 1) doesn't last forever, and 2) can encourage complacency which, as we've seen, can cause overreactions when the market fluctuates.
So, what's the bigger picture? We think spurts of volatility will be more frequent. As central banks – especially the U.S. Fed – gradually withdraw economic stimulus, we think stocks will be more prone to knee-jerk reactions in response to rising interest rates or disappointing news such as weak economic readings, a drop in oil prices, unexpected weakness in the Canadian housing market, or increased conflict with North Korea.
We think the Bank of Canada will move more slowly in tightening policy, but since 1980, in years when the U.S. Fed raised rates three times or more, stocks experienced an average of four 5% pullbacks and one 10% correction.2
We believe there's a fair amount of opportunity in the midst of uncertainty. When markets dip in response to short-term disruptions, political uncertainties or sensational headlines, these can be attractive buying opportunities when the fundamental underpinnings of the market remain intact. Currently, these underpinnings include ongoing expansion in the domestic economy, a synchronized and improving pace of growth globally, rising corporate earnings and relatively low interest rates.
We think these conditions will remain in place this year, making pullbacks – though more prolonged and material than we've experienced in recent years – temporary and an opportunity for long-term investors.
In this environment, it's important to remember volatility is normal and inevitable. Jumping in and out of the market to avoid it is not a sound strategy, in our view. Instead, to position for market moves, we recommend the following:
Having a strategy in place in advance of market pullbacks will put you in a better position to capitalize on them, if appropriate. Talk with your advisor about making choices that align with your long-term investing strategy.
*Past performance of the market is not a guarantee of how it will act in the future.
**Equity investments carry risk, including the loss of principal. There are special risks inherent in international investing, including currency, withholding taxes and high levels of taxation, political, social and economic risks.
This information is for educational and illustrative purposes only and should not be interpreted as specific investment advice. Investors should make investment decisions based on their unique investment objectives and financial situation.
1Ned Davis Research, performance of the S&P 500 Price Index.
Federal Reserve Economic Data & Ned Davis Research. Past performance is not a guarantee of what will happen in the future. 2