What’s going on?
As I write this, the S&P 500 is up more than 4.5 percent year-to-date, and the Nasdaq is doing slightly better than that. As I explained in my yearly outlook, I expect the market to end the year around 1,850. Even after the drops, our current position isn’t bad at all.
On a year-to-year basis, we’re doing even better; the S&P 500 is up more than 14 percent from last October, much higher than average annual returns. And the pullback itself is just under 4.5 percent—actually quite small and something we’ve seen a couple of times this year already.
What's more, over the past five years—a very good time for the markets from a return perspective—volatility has almost always been higher than it is now, as you can see in the following chart.
True, volatility is edging up. But it hasn’t even hit the highs of 2014, remaining closer to the lows of 2009 through 2012.
From a historical perspective, then, the bumps we’re experiencing are very normal. From a return perspective, we’re still in a very good place. Even looking at the drawdown from the peak, there’s really nothing to be concerned about yet.
So, why the worry? Returning to the chart above, the market has been incredibly calm over the past couple of years, and especially this year. Investors have come to expect that tranquility, which is a mistake. Financial markets are usually much more volatile than they have been, and that risk is at the heart of why we can make money there. You don’t get one without the other.
The question, of course, is whether the market will continue to drop. No one can say for sure. But here’s what we do know: Although prices move around, they ultimately depend on fundamentals, which are improving. I wrote the other day about supportive factors for the stock market as the economy improves, and these should act to limit any damage.
We’re in an interesting place right now. The economic recovery in the U.S. should drive markets up, but current values are already at very high levels—priced for perfection, really. In my opinion, this is what’s behind the rising volatility: the conflict between stocks being repriced to more reasonable levels, even as those reasonable levels rise with the improving economy.
We should be seeing volatility here, as the market tries to sort out the reality of the situation.
We may quite possibly see a further drop, even a significant one. Because of the improving fundamentals, though, we have something of a cushion below that will limit the damage, and possibly even set up a bounce-back.
Volatility is certain. Fortunately, we’re better positioned to weather it than we have been for years.