Learning to Embrace Volatility When Stocks Plunge

Oct 26, 2018

It’s not everyday that the Dow Jones Industrial Average Index and the S&P 500 Index® give up their gains for the year and the Nasdaq Composite Index has its worst percentage decline day in seven years. But that’s what happened when equities sold off on Wednesday, October 24, 2018 amid hints of a global equity bear market. The long and the short of the plunge? For now, it seems to be another instance of sell-offs simply being part of the deal sometimes. Of course, like other dips, this one certainly has its unique drivers.

Believe it or not, such turbulence can be exciting for those of us in the business of trying to make sense of the macro and technical factors in play. That psychology may seem counterintuitive, from volatility comes both stress and opportunity.

Factors contributing to the current market uncertainty 

Tariffs affecting the global supply chain and Federal Reserve tightening top our laundry list of this sell-off. Elsewhere, third-quarter earnings could be classified as good, but not quite as good relative to Q2. The same is true of guidance; it’s been good, not great and I think the market is looking for better than great. Two other culprits could be: 1) The dearth of buyers as share buybacks are shut off before earnings season, which is still in full swing; and 2) The strength of the U.S. Dollar has been cited in earnings conference calls as an increasing problems for US companies doing business overseas.

There are technical explanations for this market decline too. Hedge funds reduced risk by rotating out of Growth into Value in early October ahead of earnings. Also, the bulk of supply was long-only in the run-up to the 10/24 sell-off, helping to steer the market lower on relatively low volume.

And still out there looming is the November 6 midterm election, the outcome of which could have broad geopolitical implications both at home and abroad.

The psychology of embracing fundamentals amid volatility

It can be tough to take uncertainty in stride and see volatility as an investment opportunity. But in this case current fundamentals may serve as a needed deep breath for investors. They remain intact, with no signs of a discernible profit recession though from my experience, fear can be self-fulfilling.  Market losses can lead to belt tightening and a decline in spending ultimately leads to lower earnings for many different types of companies across sectors.

What this sell-off looks like is a classic late cycle coupled with investors growing wary of systemic risks (even if they don’t exist) and on the lookout for the possibility of recession (it will happen one day). In that sense, and here is where the psychology comes into play, this correction could provide a good entry point for investors.

As dramatic as sell-offs can be, so too can rebounds. One day after they sent equities plunging, several Information Technology names reported strong earnings and helped the market snap back up. For perspective, a fairly sizable 63% of global stocks are in bear market territory currently, meaning there could be high quality opportunities to explore.1

Final words

  1. This looks like a classic late cycle moment with a host of factors spooking investors.
  2. Leaning on fundamentals could serve to calm investor nerves.
  3. Buying into volatility can be a tough sell, but that is where opportunity often lies.

And by one measure, the volatility could be here to stay for a while. A BofA Merrill Lynch report suggests the flattening yield curve of recent years is right on schedule in predicting a higher volatility era, starting right about now. Notably, the report is quick to point out that doesn’t mean trouble for equities, citing the 1993—98 when Wall Street’s fear gauge, the VIX Index, jumped from about 15 to 25 while the S&P 500 Index had 22% annualized total returns.2

Category: Commentary

Topics: Macroeconomic

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