A Respite from the Volatility Storm?

By Christopher J. Wolfe, CFP® and CFA Chief Investment Officer, First Republic Private Wealth Management
December 27, 2018

A Respite from the Volatility Storm?

It has been a wild ride on the high seas of capital markets in the past week. 

It has been a wild ride on the high seas of capital markets in the past week. After falling more than 2,700 points in the prior seven days, the Dow Jones Industrials rebounded by its highest point total ever, 1,046 points, on Wednesday, December 26. While that rally was a welcome respite from the volatility and downtrend over the week, the Dow is still down more than 10% for the month of December.

In our view, a number of conditions for this volatility storm have converged, making the sell-off and the rebound much more exaggerated than they otherwise would have been. Indeed, the markets continue to fluctuate against a backdrop of low liquidity, heightening political and headline risk, downward earnings revisions, falling consumer confidence, rising dominance of computer trading (which follows rules, often without regard to business fundamentals), a government shutdown, and an almost 10-year bull market that is sensitive to profit taking. And this is only a partial list.  

We think one of the more important points from Wednesday’s massive rally — the largest point change in Dow Jones history (1,046) and the eighth largest by percentage (5%) — in the U.S. equity markets provides the first meaningful evidence that the market continues to respond favorably to positive data. Notably, a positive surprise in manufacturing data may have helped spark the turn on Wednesday, which carried into Thursday. We expect market perceptions to continue to change quickly, and computer trading will magnify market moves.

The dichotomy for investors navigating this storm is between the real and potential risks. Recent positive news is real (inflation is low, very low risk of recession, profit growth will be lower but positive in 2019, etc.), while the fears largely remain potential (e.g., further headline risk, no trade resolution in 2019, additional trade responses from existing partners, a never-ending government shutdown). While the government shutdown will likely continue to weigh on investors’ near-term thinking, we believe a focus on the real data, which suggests the underlying growth dynamics of the U.S. economy are still in a growth (but slowing from great to good) mode, is the more relevant endeavor. Undeniably, the holiday retail selling season was very strong — signaling that consumers continue to behave in line with their rising paychecks, fueled by tax cuts and falling energy prices, not by falling stocks.  

While most of the risk factors we have already highlighted in our previous publications remain, the valuation case is becoming more compelling, and resolutions to any number of political headwinds would be a large positive for stocks, in our view. In the near term, we expect stocks to weather the storm that may last into January, as companies still need to adjust their earnings to a lower growth environment and higher interest rates — a process that will run into early next year. Yet, our counsel remains the same: aggressively manage risk by staying close to your long-term equity allocations, shifting toward active risk management strategies in stocks and bonds, and be patient with cash to rebalance. For clients underweight in equities, we think selectively adding on further pullbacks is prudent given our constructive view on economic growth. 

Return of Major Indices as of 12/26/2018

Chart December 2018 

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