Summer calm meets heightened volatility
By Kyle Tetting
Summer is supposed to be a quiet stretch for stocks, especially the month of August. With warm weather and summer vacations, most traders would rather be at the beach than on a computer. Typically, trading volumes are lower, and daily price swings are less volatile. Stock markets in 2019 have given investors plenty of reasons to head to the beach, but this August has offered more than usual to think about.
Overall, 2019 has been quiet. The CBOE Volatility Index, a measure of expectations for volatility in stocks, started the year at elevated levels, but investors settled into 2019 as stocks drifted higher. Analysts had anticipated a weak stretch of earnings for the S&P 500 across the first half of 2019, and the eventual impact was a nonevent.
Other measures of market volatility also remained muted for much of 2019. Through the first seven months, the S&P moved 1% or more in either direction on just 19 days—and the majority were moves higher. On average since 1950, investors should have expected 29 days with movements of 1% or more.
The yield on junk bonds, which typically jumps at uncertainty as investors demand a premium for lower-quality fare, also remained subdued for much of the middle of the year. Investors largely were unfazed by earlier-year uncertainties.
During the month of August, however, investors have been given more to think about. Although the concerns are not new, they feel more pressing now than they have in recent months. As a result, measures of volatility and expected volatility have spiked.
- During August, the Volatility Index reached its highest level since Jan. 3.
- On eight of the first 15 trading days in August, the S&P moved greater than 1%.
- Investors have begun to demand more from lower-quality bonds.
While August volatility isn’t unprecedented (We need only look to the 2015 impact of China’s surprise currency devaluation.), August 2019 stands in contrast to the typically quiet stretch we have come to expect.
Recession concerns are at the core of reinvigorated volatility. The inverted yield curve, ongoing trade wars, the age of the current expansion and slowing global growth all point to worries about when the economy eventually reverses direction. While all those concerns are real and meaningful issues that challenge U.S. economic growth, they don’t necessarily spell doom for stocks.
For starters, consider that the next recession is unlikely to resemble the last recession. A broad range of recessionary causes, durations and outcomes makes it difficult to describe how the average recession should look, but it is fair to say that the last recession was atypical. Financial institutions, whose failures escalated an already significant slowdown 10 years ago, are far better capitalized today. Human nature has us expect our recent experiences to replay pretty much the same, but lightning seldom strikes the same place twice.
As for recessionary indicators, an inverted yield curve may not be as telltale this time. Historically, when the yield on longer-dated bonds dips below the yield on shorter-dated bonds, it suggests expectations for an economic slowdown, as investors lock in safer money longer to get through tough times.
Part of why the indicator has been so predictive, at least in the past, is that the very act of locking in that money long-term removes its ability to work its way through the financial system. The unwillingness to take risk becomes a self-fulfilling prophecy, and growth slows.
However, with near-zero or negative rates on government bonds around much of the rest of the world, money flooding into U.S. Treasurys is not strictly a bet against future growth. Rather, it’s a reflection of the fact that Treasury rates offer better returns than a German bund or a British gilt. Higher demand, in turn, leads to lower rates on long-term bonds, resulting in a flat or inverted yield curve.
The greatest concern may be slowing global growth, especially if this time is different. The saying used to be, “When America sneezes, the world catches a cold,” but maybe it will play the other way around. As a net importer, though, the U.S. is less dependent on global growth than an export-dependent country like Germany. As a result, while the global slowdown certainly will weigh on the U.S. economy, the impact should be muted.
A recession is inevitable, owing to the ebbs and flows of the economic cycle, but nothing suggests a downturn must come soon. However, the shifting landscape points to an environment that is likely to remain volatile.
Further, the risk-reward trade-offs that have favored a healthy allocation to stocks have begun to turn. That does not mean investors should abandon stocks. Rather, investors should reevaluate their desire and need for risk and adjust their expectations for reward accordingly.
Just as we adapt our expectations from one season to the next, so should we as investors stay balanced and resilient as the markets respond to forces beyond our control.
Kyle Tetting is director of research and an investment advisor at Landaas & Company.
How to handle fears of recession, a Money Talk Video with Bob Landaas and Kyle Tetting
Volatility: Stock market vs. your portfolio, a Money Talk Video with Kyle Tetting
Risk: How much can you stand? How much do you need? A Money Talk Video with Isabelle Wiemero
Yield curve: The shape of interest rates, a Money Talk Video with Kyle Tetting
Leaning into the curve, a Money Talk article
Historic economic growth vs. long-term investing, a Money Talk article
(initially posted Aug. 27, 2019)
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