The current volatility we’re witnessing in equity markets both locally and globally is nothing new, but does come after a very long period of largely uninterrupted growth with the lowest levels of volatility on record. This however won’t come as a surprise for many of our clients as we’ve been expecting it, AND positioning client portfolios accordingly for quite some time.

What happened?

We’ve now seen a circa 6% fall in equity markets over the last couple of days. The “large” share price falls began in the US equity market on Friday (Saturday our time) and continued on Monday, and have reverberated across equity markets globally. Whilst the headlines (aka the noise) would have you believe that we’re now in a bear market or that the bubble has finally popped, the reality of it is that we’re just seeing a rather normal pullback in equity markets which have risen very strongly over the last 12 months or so – eg. the broader US equity market (not the Dow Jones) was up 22% in 2017 whilst the technology heavy NASDAQ was up nearly 30%.

Why is it happening?

Investors taking profits is nothing new. But 2 things are rather unique or different this time around, and are somewhat linked:

1. The rise of ETFs and passive investing
2. The disregard for valuations

The rise of ETFs now means that when investors take profits, they’re not being selective as to which stocks they trim or sell nor are they being selective as to how much they trim from each stock. What they are doing is pushing a button to sell their ETF, which holds the whole market, which then sells the whole market indiscriminately. The same is true for passive investing. Like with everything, there are positives and negatives to ETFs and passive investing – low cost investing comes at a price.

The disregard for valuations is really a function of the rise in momentum investing, which has been exacerbated by rates and bond yields being too low for too long. Investors generally prefer to buy the overvalued investment whose price keeps rising, but don’t want to buy or top up the undervalued investment whose price is moving sideways or downwards. Momentum trading works until it doesn’t and valuations matter over the medium to longer term.

Is there anything else to consider?

Nothing has really changed from a fundamental perspective. What spooked US markets the end of last week was the stronger than expected jobs numbers and further evidence of rising US wages. This is nothing new and shouldn’t be a surprise to anyone – it certainly isn’t to us.

Markets took the data to assume that the US Fed would have to go much harder on rate rises this year and next. But the data shouldn’t have been surprising and the US Fed has made it abundantly clear it will raise rates and withdraw stimulus in a very slow and measured fashion. The last thing the US Fed wants is to be the cause of recession or massive market correction by jacking up rates too quickly. The Fed will likely raise rates 3 times this year and another 3 times next year before pausing, whilst slowing withdrawing other stimulus at the same time.

Global debt levels are now higher than they were pre-GFC. Yes, stimulus needs to be removed, but in a measured and well telegraphed fashion so as to not cause a full market meltdown. Remember, the easiest way to get rid of debt is to inflate it away, and inflation is better than deflation. A little of bit of inflation with slowly rising rates are conditions that are still broadly supportive of both equities and bonds.

What should investors do?

Not much to be honest. A market pullback is a great time to:

1. Ensure your portfolio is well diversified
2. Invest opportunistically
3. Set a plan to semi-regularly take profits (trim winners) and top up (losers)
4. Remember your goals and objectives (hopefully they’re mostly long term)
5. Remember that investing in the market comes with risk

Source: Chris Lioutas, Insight Investment Consultants – 6 February 2018