Has It Really Been That Long?
This week, we entered the ninth year of the current bull market (marked by the bottom on March 9, 2009). After eight years (second longest since WWII), is it human nature to question how long it will continue? When things are going well for an extended period, you might be tempted to believe they will keep going…even if you know the logic doesn’t support your beliefs.
Interestingly, the opposite isn’t always true. When things aren’t going well, many question if the current state will ever improve. The doom and gloom at the beginning of this run was a good example. If you pull surveys and/or articles from March 2009, I doubt you will find many (if any) that predicted the current situation. After all, this time it was different…it always is (on both sides). Many questioned if, not when, we would recover. But, recover we did!
When considering market patterns, time alone does not and will not dictate when or if a market should move higher or retreat. Fundamentals and expectations will determine future market movements. I would argue the same applies to most scenarios.
Has it really been eight years?
There are multiple “experts” who question the starting point. But, for now, let’s assume it is the second longest bull run since WWII. Just in case you were wondering how far we must go until we reach the longest…113 months (10/1990-03/2000). Current “streak” is 96 months. Another 18 months to become the longest bull market.
How are we defining the bull market?
We are referring to the S&P 500 Index and measuring the period without a correction…defined as a 20% pullback. We’ve had a couple of 10% pullbacks during this time frame, but none that equaled 20% or more. The data is interesting, but what does it mean going forward?
Fed considers low volatility
“Market participants continued to report substantial uncertainty about potential changes in fiscal, regulatory, and other government policies. Nonetheless, measures of implied volatility of various asset prices remained low.” Meeting minutes released 1/22/17.
Some question whether the Fed should be concerned about equity market conditions. Technically, the Fed has a dual mandate which is to “foster economic conditions that achieve both stable prices and maximum sustainable employment.” In other words, their goals are to balance inflation (price stability) and employment. Should current market conditions affect policy decisions?
Of course, Fed decisions will affect markets, but should market conditions impact Fed decisions? If yes, how much impact should they have?
Let’s consider the period leading up to last year’s Brexit vote. The Fed mentioned the uncertainty surrounding this event when releasing minutes prior to the vote (no rate change). With the benefit of hindsight (makes everything so easy), we know the Brexit vote was a non-event (at least after the initial surprise). The point being…did market conditions affect the Fed’s decisions? Would they have raised rates without the pending vote? Probably not, but…
The real impact of the Brexit decision may occur when the actual event (rather than the vote) occurs…we’ll have to wait and see. France is the next country to consider this path. No direct Fraxit(?) vote is scheduled, but the two leading candidates differ in opinion of whether to leave the European Union. Election victory may hinge on this difference. France may be looking for a change. Like Britain (and arguably the US), voters may be looking for a change from the current state. We’ll see soon enough.
When measuring the level of investor “uncertainty”, the most common tool is the Volatility Index or “VIX.” The index is often called the “fear index” as it measures the market’s expectation of 30-day volatility. Rather than measuring stock prices, the Chicago Board of Option Exchange (CBOE) measures volatility (implied) based on current option prices. Basically, the greater the value, the greater the expected movement in price of the underlying stocks in the next 30 days. This is a tool used by traders when pricing options.
Although the fear index gained its name based on a one-sided consideration…downside volatility. It is important to remember volatility measures the expectation of movement rather than direction. The change can be upward or downward. The term Fear Index only addresses one side of the equation.
What is the VIX used for?
Volatility is a key consideration when pricing options. Options have value when they are “in the money.” When considering calls, options are considered in the money when the stock is trading above the strike price. For puts, the underlying stock is in the money when its price is below the strike price. If you want to discuss this further, please let me know. For now, I will move on.
Some traders use the index as a contrarian indicator. The theory is to do the opposite of the rest of the market. This is especially true if you believe markets “mean revert.” If this is the case, periods of extreme low volatility require an increase in volatility to get back to “normal.” A contrarian may choose to sell stocks when volatility is low (especially for prolonged periods of time) and buy when volatility is high. There are multiple other strategies available when considering options, but that is beyond the scope of today’s post.
Consider the Fed comment
Let’s dissect the comment taken from the Fed minutes. First, they acknowledge that market participants report a high level of uncertainty. I believe this is true. This is a concern I hear often. Interesting, the concerns were more frequent and louder before the markets reached new highs. Higher markets tend to quiet fears…but, is that a good thing? The Fed addresses this in the next sentence.
“Nonetheless, measures of implied volatility of various asset prices remained low.” While I was not in the meeting, I assume they are concerned about being the cause of increased volatility or market correction. If they raise rates, will markets fall? An interesting question is…would the markets have maintained the bull run and relatively low volatility without past Fed actions? No way to tell, but…
I would argue that since 2009, most threats to market corrections were soothed via Fed actions (QE decisions). As the Fed shifts from its long term accommodative stance, what will happen? This is the current struggle for the Fed. Therefore, markets are considered, with decisions expanding beyond the dual mandate.
If markets fall, do employers stop hiring or even worse, lay off? If profits decrease, will companies pull back on investment? Does a correction affect price stability and employment? You can walk through the various scenarios.
But, at some point, the Fed must raise rates. I feel it is dangerous to stay this low because we don’t know what the future holds. What if the market corrects without Fed action? Besides, eight years of low rates hasn’t created the growth desired.
So, the Fed considers low volatility; considers the choices and raises rates by a quarter point in the upcoming meeting. I would be surprised if this does not happen. The decision leads to the point of this post. Have the markets become complacent? Has the market lost its fear of risk? Will risk appetite change as rates increase?
Have the markets become complacent?
I wait for the day the headline reads that 30-year fixed mortgages have crossed 5% (or 7%). There are some who haven’t seen rates outside of the 4% (give or take) range. I think it will be interesting to see the response. Of course, many readers remember double digit rates.
I equally consider (with less humor) the response to a 20% (or more) correction. The same group that hasn’t witnessed a 6% mortgage rate, haven’t struggled with the emotions of a market correction. I fear many market participants have become complacent. Apparently, the Fed agrees.
Even though the Fed questions the low level of volatility given current political, fiscal and market conditions; they need to focus on their mandate(s). We must do the same.
On some days, I think Stephanie’s mandate is drive her parents crazy. Or maybe, I have become complacent with the fact that she is a well behaved young girl…with bouts of volatility. I asked Steph about her mandate. First… “What’s a mandate?” “It is a set of rules and ideas that help you determine your choices.”
“My mandate is to have fun.” Sounds about right for a 10-year old. If you are a regular reader, you know we (Steph and I) have fun most of the time. She makes me younger (most days). We do things that I wouldn’t normally do because I am “an adult.”
As I thought about the complacency of the markets, I considered the complacency of parenting. Just when we get used to a certain routine, the child grows out of it. In the new office, there is a new mom…the one who used to make cake pops. She has a 6-month-old boy at home. I look at her and remember the days of limited sleep. But, we survived on limited sleep. Just when they sleep through the night, they begin walking and a new adventure begins. By the way, she isn’t baking a lot of cake pops these days.
So, as I considered Steph’s mandate, I wondered if I have become complacent. Ten years old is a fun and for the most part easy time as a parent (at least for me). But, ten quickly turns into teens…is volatility looming?
We are enjoying the new office. Steph has created her own space. While there haven’t been any cake pops, there are two big dogs who come to the office from time to time (mostly Wednesdays). Her first question when I pick her up from school is “are the dogs there today?” quickly followed by “can I have the tablet?” The balance between child and teenager continues…
Media tends to focus on “beating the market.” They “sell” the idea of informed trading. Our mandate is to make informed money decisions rather than trading decisions; we balance the need for return that achieves goals while understanding the potential risk. We prefer to focus on the decisions that carry less risk which are typically the ones over which we have greater control.
We know there will be volatility (in many potential forms) throughout your financial life. My goal is to share and review potential setbacks while giving you permission to enjoy today.
Just like the Fed, we understand the obvious impact of various choices and consider the potential unknown. I think most of us can relate to a period where we became complacent with the status quo when things are (hopefully) or were going well. I also think most of us have encountered times when things weren’t going well and it seemed like the situation would never change.
No matter whether we are considering markets or other areas of life, remember…for the most part, time is not the determining factor for change. Change happens based on fundamentals and environment.
I think the best advice of this post comes from Stephanie's mandate…” have fun.”
As always, thank you for reading. If you have questions or want to discuss ways to offset (or dare I say bet on) the potential for increased volatility, please let me know.
By the way…as interesting as the 8-year bull run is, we have gone 103 trading sessions (back to October 11) without a 1% daily decline of the S&P 500 or the Dow 30. Is it any wonder volatility remains at an extended, low level?
Hi. I write and distribute a letter like this one every week. In the letter, I share thoughts about financial planning and often include opinions or experiences from my 10-year old daughter...Stephanie. If you would like to be added to the distribution list (I am sure you don't get enough emails already)...please send me your email address. I will happily add you. Thanks.
Schedule a Meeting: https://disciplinedmoney.acuityscheduling.com