Volatility Returns: It was Fun While it Lasted (Sort Of)
"Don't confuse lack of volatility with stability, ever." -- Nassim Nicholas Taleb
Most U.S. stock market indexes achieved a notable record by late January, having amassed nearly 400 days without a measurable pullback of more than a few percentage points. Such a long period with no measurable declines is unusual and had lulled many into a distinct aura of complacency, a disconcerting place, as we wrote warningly in last quarter's column. Wait... stability is disconcerting? Yes, in that it's not a normal state of affairs for economies or markets to be in.
When markets are steady for a very long time, it can lull investors into believing this abnormally benign period can go on forever. In classic "It's all good" mentality, time horizons can lengthen and worries can be minimized. However, when investors "wake up" after such a period and reassert their right to worry, the initial response can be abrupt. As the quote above reminds us, smooth markets don't change the fact that underlying economic fundamentals are necessarily lumpy--ebbing and flowing with changes in weather, time of year, natural disasters, demographics, geopolitics, and a host of other things. Underlying almost every function of our economy are individual human decisions. And those, as we well know, can be anything but smooth, rational, or predictable.
The key when dealing with markets in general and individual investments in specific is to keep one's focus squarely on the basic relationship between underlying fundamentals relative to what investors are paying for those fundamentals and to ignore the swings. In fact, volatility and mispricing create opportunity and are not to be feared for those with a long-term time horizon.
Take the trading on February 2, 2018, for example, when the Dow dropped more than 650 points and most other major indexes declined in similar fashion. The downturn seemed especially sharp because we had become so used to markets moving only in one, northerly direction. The pullback was attributed by many to be fear over rising rates spawned by stronger economic numbers, specifically related to wage growth.
Let's reevaluate this reasoning: 1) Isn't faster wage growth a good thing? 2) Won't faster wage growth in the long run lead to employees with more purchasing power? 3) Isn't a bit higher rate of inflation a good thing, in that it allows companies some pricing flexibility? Getting from where we were to the new "normal" is likely going to be a lumpy process, but in the end it should result in more people with jobs, more consumers, and a country in a much healthier and sustainable place.
Jobs and taxes
The jobs numbers have been improving as we've clawed our way out from the double-digit unemployment rate recorded just after the financial crisis of 2008. Competition for workers has been fierce, and incentives (in the form of hiring and retention bonuses, expanded leave policies, and other benefits aimed at attracting workers) were occurring even before the Tax Cuts and Jobs Act was passed in December 2017. With a number of states, companies, and municipalities raising their minimum wage on January 1, 2018, is it really that surprising there has been a bit of upward pressure on wage growth?
We have a new tax law whose implications are still being worked through by both corporations and individuals. Between changes to tax rates, overseas earnings, changes in debt deductibility, and even such things as legal expenses and the ability to absorb some longstanding employee perks (such as parking or bus passes) on a pretax basis, no one is quite sure until hundreds of scenarios are run what the net impact will be. Companies are noodling all sorts of different combinations to maximize their businesses under this new tax regime in an attempt to find the optimal combination of actions--increasing wages, enhancing training, increasing dividends, installing new technology--that will yield them the best total stakeholder response. While tough to predict with specificity, it would seem only common sense to presume that upward wage pressure will continue as 2018 progresses.
So what next?
Among the few claims we as prognosticators can lean toward, then, are directionality and that economic activity seems to be on a more upward-sloping trajectory than we've experienced over the past 10 years; and odds are the new tax law will support that uptick, at least on the margin. As companies contemplate where to put new production lines, whether or not to do a capital-intensive acquisition, or how to retain workers, the tax law seems to be helping sway many of those decisions into investing in the U.S. and its workforce.
We understand there are a lot of "ifs" and "unknowns" in the mix, and in that murkiness lies investor angst. So although we believe that underlying fundamentals remain solid and the direction of economic activity is likely to move ahead, there is plenty to keep an eye on to ensure timing and progress remain directionally appropriate.
The extent to which markets continue to swing more widely provides ample opportunity for investors to deploy sidelined cash, rebalance regularly, and take advantage of market swings that are out of sync with improving long-term fundamentals. Watching those fundamentals and the host of critical potential bottlenecks or crossover points will keep us all busy as the year plays out--most likely with a higher degree of volatility than we have become accustomed to.
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