Author: Eric Cramer, CFP®, CFA®
We’ve seen stock market volatility lately after an extended period of unprecedented calm.
What could cause the markets to erupt like this? Don’t believe the headlines that it was a slower employment report, or even that it was the Japanese “carry trade.” We need a softer job market to relieve some of the pressure employers face when looking for new hires. We’ve known the carry trade (borrowing cheaply from Japan and investing at a higher rate in the U.S. and elsewhere) was ending. The financial media writes these headlines because the human brain needs a “story” to process information, but those headlines aren’t necessarily the most impactful headlines or why we’re seeing such stock market volatility.
We estimate that approximately 70% of all stock market trading volume comes from split-second algorithmic trading. It’s driven by computer programs, and it happens so fast that the role of humans is only to design the trading algorithms (even that is moving to AI) and to oversee things in case the actions of the algorithms get too extreme, and someone has to pull the plug. The regulators have put so-called “stock market circuit breakers” in place to pause, or even shut down, the stock market out of fear that the algorithms can’t be stopped. Many of the algorithms read headlines, look at short-term trends (think of a few seconds as short-term), and then place trades in microseconds. Every once in a while all the algorithms gang up on the market and accelerate the pace of the ups and downs causing stock market volatility.
After months of abnormally calm markets, the most relevant headlines might actually be about how some of the high-flying technology stocks are not hitting their revenue/income expectations. Much of the run-up in tech stocks was probably driven by algorithms, but after a pretty big sell-off, value stocks are stealing the show. Value stocks have a long-term history of outperforming growth stocks, but the day-to-day flips between the two sides of the market are impossible to predict.
The Fed really does care about the value of your portfolio.
It is said in some circles that the Federal Reserve isn’t concerned about the markets and is instead focused on the economy, but this just isn’t true. Ever since the Tech bubble was growing uncomfortably large in the late 1990s (feel familiar?) the Fed has cared a LOT about the value of your portfolio. Ideally, some would say, the Fed would let excessive risk-taking by investors get punished. Healthy markets count on the Fed letting risk and reward be properly priced.
But just as some banks are “too big to fail,” Americans’ portfolios are too big a part of the economic health of the country to let them fail. What the Fed knows is this: if you rescue investors’ portfolios they will spend more, start more businesses, and relieve the government from spending on the social safety net. It is the ultimate “trickle-down” approach to economics and has become unwritten doctrine. The half of the U.S. population without any exposure to the stock market may suffer from the Fed’s actions in the form of inflationary swings, but the investor class gets to benefit from these policies.
The only time the Fed backs away from this approach is when inflation is way too high, which it was over the past couple of years (but isn’t anymore). The Fed went too far in stimulating the economy after the pandemic. And then it was too late raising rates and is now too late in lowering rates. The Fed has been too extreme and too late in every rate decision it has made for twenty-five years, but it has helped investors and it’s going to rescue us again. With rates as high as they are now the Fed once again owns something called the “Fed Put,” which is nothing more than the ability to dramatically lower short-term interest rates to make all risky assets worth more. This will likely start in September, if not sooner, and may even go too far.
But what about inflation?
Inflation is over; it’s yesterday’s news; it’s a distant memory. The headlines aren’t telling you this yet, but we’ve been saying it all year. This will leave the Fed free to cut rates just as soon as it shows up in the latest economic data.
Here are a few key pieces of evidence for you:
- The Consumer Price Index (CPI) uses a lagged indicator of housing inflation called the Owners’ Equivalent Rent (OER) that presumes we are all renting. Instead, almost 70% of households own their homes and do not face rent increases from the boom in housing prices. The OER accounts for about one-quarter of CPI but should be far less. In other words, CPI significantly overstates inflation in the current environment.
- Housing prices are starting to crack in numerous markets around the country. Airbnb properties are naturally second or third homes for most owners and are what you might call a marginal home purchase. The prices of these homes are collapsing in numerous cities, suggesting an over-supply of units that is beginning to bleed into the single-family home market. This may be a correction from the massive buying spree of homes that resulted from private equity groups raising billions of $ to turn the homes into an investible asset class.
- Numerous retailers have been lowering prices. While we may see higher headline prices at some retailers, the proliferation of house brands at the grocery stores, along with widespread price cuts by Walmart and Target, is actually lowering average ticket prices for most consumers.
- Used car prices have collapsed and new car prices are becoming much more competitive for all but the most popular models.
- Wage inflation has slowed dramatically. Wages are yet another component of inflation, and with the rate of increase dropping the Fed will feel much more comfortable that the upward spiral has ended.
How to handle stock market volatility, it’s your friend!
When we manage the BIP Hedged Equity, BIP Hedged Yield, and BIP Concentrated Stock strategies, we use some math to adjust our options strategies, which are the backbone of our approach. That includes referencing the price of expected volatility in the markets (the “VIX”), which recently quadrupled in one week. This means we can generate a LOT of income selling options; we think this is good for our clients. In other words, these strategies were designed for stock market volatility.
But even our primary portfolios can do better in volatile times. If the remainder of this year is volatile, it might just give us the chance to “buy low and sell high” a few times in our clients’ portfolios. Rebalancing is often discussed as a method of risk control, but it can also present opportunities to increase your return. The key principle at play is that it usually makes sense to let the markets “gap down” before buying, and “gap up” before selling.
OK, maybe you need some of your capital to avoid as much stock market volatility as possible. We do have something for you too! You might have used cash for this in the past, but our BIP Short-Term Tactical strategy relies on the extremely liquid Treasury market to offer both liquidity and yield for this part of your holdings. Bank accounts have FDIC limits that can expose savers to theoretically limitless risk for balances above those limits, so putting excess cash to work in the Treasury market where investments are backed by the full faith and credit of the U.S. government could be a smart way to enjoy healthy returns while reducing risk.
Managing that volatility so that it works for you is what having an optimal financial plan is all about. Your Personal Wealth Advisor has a full toolkit of strategies that can be customized for your situation. With all of our public market strategies built around the concept of volatility, just remember this phrase, “Volatility is Your Friend!”
Frequently Asked Questions
Why is the stock market down?
We estimate that approximately 70% of all stock market trading volume comes from split-second algorithmic trading. Many of the algorithms read headlines, look at short-term trends, and then place trades in microseconds. Every once in a while all the algorithms gang up on the market and accelerate the pace of the ups and downs. After months of abnormally calm markets, the most relevant headlines might actually be about how some of the high-flying technology stocks are not hitting their revenue/income expectations. Much of the run-up in tech stocks was probably driven by algorithms, but after a pretty big sell-off, value stocks are stealing the show.
What is market volatility?
Market indexes gain and lose every day. The larger and more often these price swings happen, the more volatile the markets are said to be. The VIX measures expected volatility.
What is the VIX index?
VIX is a ticker symbol for the Chicago Board Options Exchange’s CBOE Volatility Index, which measures the price of expected volatility in the stock market based on S&P 500 index options.
What is the Fed Put?
The “Fed Put” is the belief that the Fed will step in to dramatically lower short-term interest rates to make all risky assets worth more and buoy markets if the price of markets falls to a certain level.
This post is provided for informational purposes only. Specific investments may not be suitable for all investors and no offer or recommendation of any investment or investing strategy is intended. The opinions in this commentary are as of the posting date and are subject to change. Information has been obtained from third-party sources we consider reliable, but we do not guarantee the facts cited are accurate or complete. This material is not intended to be relied upon as a forecast or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict the performance of any investment. We may execute transactions in securities that may not be consistent with what is mentioned here. Investors should consult their financial advisor on the strategy best for them. Past performance is no guarantee of future results. All investments involve risks including loss of principal.