Market Volatility Bumps Investors as The Fed Prepares to Grind the Market’s Gears

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In the last week, "market whiplash" has been in full effect, but should investors be concerned about the recent uptick in volatility? Mission Wealth’s Portfolio Manager Kieran Osborne comments that the market swings appear to be a reversion to historically normal levels of risk, which may create unique investment opportunities.

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Should investors be concerned about the recent uptick in volatility?

A globally diversified portfolio may provide superior risk-adjusted performance over the long term...

The S&P 500 Index has been making investors woozy with its up-and-down contortions over the last week. This volatility is due to the much-anticipated upcoming Fed decision to take away the proverbial punchbowl, by ending “tapering,” according to Kieran Osborne, portfolio manager at Mission Wealth. While volatility has increased across equity markets after reaching a low-point midway through the year, it appears to be a reversion to historically normal levels of risk. This has been a period of abnormally low volatility in the last few years, brought about by the Federal Reserve’s (Fed’s) “greasing” of the market’s gears, in the form of quantitative easing (QE). With the Fed expected to end QE, the market may grind a little more going forward.

Though this is a bumpy ride, a glaring positive is that the continually improving U.S. economy is the reason the Fed believes QE is no longer necessary, Osborne said. Additionally, where there is risk, there is opportunity. Volatility can lead to greater rebalancing opportunities and enhanced return potential across asset classes. Taking a globally diversified approach to portfolio construction may prove beneficial, particularly with diverging central bank policies around the world, which may lead to upside potential.

It is widely believed that the Fed will announce the end of QE at its October 29 FOMC statement release. The Fed won’t begin tightening right away and has communicated that its balance sheet should remain steady for some time. Nonetheless, volatility has come back to markets. The most commonly followed volatility index, the Chicago Board Options Exchange Volatility Index* (VIX Index), which measures the implied volatility in S&P 500 futures contracts, hit a low of 10.32 on July 3 and has subsequently more than doubled, closing above 24.50 on October 13. While that appears to be a relatively large move, at the height of the financial crisis in 2008, the VIX exceeded 80.00. Over the past 5 years, the VIX has averaged 18.90, so the recent uptick in volatility is a return to more "normal" market levels, Osborne said.

The latest increase in the VIX appears to be a natural reaction to the anticipated conclusion of the Fed’s tapering. Over the past five years, the correlation (the degree to which one variable is related to another) between the Fed’s balance sheet and the S&P 500 has been 0.97. This is amazingly high; a correlation of 1 means that both assets move in perfect lock-step with one another. According to Osborne, if this relationship persists as the Fed’s balance sheet flattens out, then the upside potential for U.S. equities may prove more moderate than in recent years.

The most recent period when the Fed discontinued QE and its balance sheet reached a plateau was between July 2011 and October 2012. The market initially sold off in anticipation of the end to QE, but eventually bounced back, as the market anticipated another round of stimulus (the current QE program). There was also a substantial increase in market volatility initially, which subsequently subsided. While volatility did decrease, it remained above the levels generally witnessed this year.

Increased volatility is not necessarily bad for stocks, Osborne said. Though larger market pull-backs may be experienced as a consequence of the greater swings, they are a “return to the norm.” (The S&P 500 hasn’t experienced a 10% pull-back in over three years; historically, 10% pull-backs occur once a year, while 5% corrections occur three times a year.) At the same time, the reason the Fed is ending tapering and will eventually begin to tighten is due to a brighter economic outlook. The economic recovery continues to gain traction, with estimates for +3% GDP growth rates over the upcoming years, which may help underpin strength in corporate earnings.

It’s possible that attractive upside potential may be found abroad. International central banks are likely to follow much different monetary policies than the Fed, Osborne said, which may act as positive catalysts for international stocks. The Bank of Japan continues to aggressively expand its balance sheet, while the European Central Bank (ECB) has laid out steps to purchase Sovereign bonds. If similarly high correlations hold between international stock markets and international central bank balance sheets as that experienced in the U.S., then international stocks could offer attractive upside potential.

From a rebalancing standpoint, increased volatility is a positive, Osborne said, as it often exacerbates the divergence in asset class returns in any one time period. Implementing a disciplined approach to investment rebalancing implicitly forces a “buy low, sell high” style. Increased volatility may therefore create better selling opportunities (selling higher) and more attractive buying levels (buying lower). A disciplined, periodic approach to rebalancing may inherently take advantage of the current dynamics.

While we may be entering a period of heightened volatility, Osborne believes it is likely a return to more normal market levels, as the effects of QE wear off. A globally diversified portfolio may provide superior risk-adjusted performance over the long term, he said, allowing investors to gain exposures to areas of the world where positive macro dynamics may play out, and ultimately prove beneficial in meeting investor objectives.

  • The VIX commonly serves as a gauge for the level of “fear” in US equity markets: As the market becomes more optimistic, the VIX typically declines; as the market becomes more pessimistic, the VIX typically increases.

About Mission Wealth
Mission Wealth was founded on a vision to empower affluent families to pursue their financial dreams. When built, they saw a demand for something different from what other financial services firms were providing. To meet this demand, Mission Wealth was founded on the principles of objective advice, proactive financial planning, and coordination with other professional advisers, including accountants, attorneys, and bankers. Mission Wealth does not sell any internal products; therefore, the recommendations they make are solely in the client’s best interests. Their client-centric planning process acknowledges clients and their needs to keep them on track and provide peace of mind. Mission Wealth’s team coordinates with professional advisers to ensure effective integration of all financial decisions. For more information on Mission Wealth, please visit http://www.missionwealth.com.

Mission Wealth is a Registered Investment Adviser. This document is solely for informational purposes, no investments are recommended. Advisory services are only offered to clients or prospective clients where Mission Wealth and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Mission Wealth unless a client service agreement is in place.

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Marcie Lund
Mission Wealth
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