Volatility Makes a Comeback

After a long period of strong stock market returns with lower-than-average volatility (2017 witnessed the historical best ratio of high returns versus low volatility), a sudden drop over a few days or weeks always seems to come as a surprise for investors. It also makes for great headlines, which tends to feed client fears about their investments. The fact that market volatility stirs investors’ emotions is quite normal. Then again, market downturns are also, well, normal.

Just a quick look at the chart below, depicting the S&P/TSX Composite Index since the year 2000, shows that growth is not achieved in a straight line; there are always drops along the way. It also serves as a reminder that market movements can be swift, in either direction. Trying to time the market is often fruitless.

Graphic

Source: Bloomberg

The question for many is what caused this most recent decline in the markets and will it be a short-term bump in the road or is it the beginning of a longer period of negative returns. There can be many reasons behind this most recent move in the stock markets: fear of inflation following recent data showing an increase in wages, expected tightening of monetary policies from central banks, the unwinding of certain algorithm-driven strategies, profit-taking after following a solid multi-year run. Much of the trading has been a result of automation rather than fundamental traders. We’ve seen a rising presence of risk parity or volatility targeting strategies, which buy the market when volatility goes down and sell when it goes up – potentially magnifying the movements.

From our perspective as fundamental bottom-up investors, our focus is on company results which are still strong – and valuations, although not cheap, are still reasonable. We will continue to apply our disciplined investment process and concentrate on companies that meet the following four criteria:
1. Attractive and understandable business model
2. Solid balance sheet
3. Strong operational outlook
4. Compelling valuation

This equity pullback has improved valuations and prospects for long-term returns. The best opportunities present themselves when the market is at reasonable or depressed multiples and normal or depressed earnings, and while valuations have normalized, earnings expectations remain elevated.

While market declines are never comfortable, investment decisions should not be driven by emotions that are stirred up by these events. Unless there have been changes in your financial situation or objectives, you should stick with the investment plan that was put in place to help you realize your goals.