Volatility Is an Opportunity for Investors
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In January, the market experienced its biggest correction since 2016. The S&P 500 Index dropped over 10% in eight trading days beginning January 29. Many investors found themselves frightened as the VIX, a measure of volatility, spiked higher by over 200%. Data shows this fear was misplaced, as volatility has had little effect on the long-term performance of equities, and in fact often creates opportunity. Some of the highest daily returns in the equity markets, even over the long term, occur after large sell-offs.
The January decline, which shaved $2 trillion of value off the S&P 500, felt especially awful given the context. There was an uncharacteristically low amount of volatility during the previous 15 months. Between November 2016 and January 2017, the largest daily decline for the S&P 500 was 2.8%. For comparison, since the turn of the century, markets have averaged a drawdown of 16% at some point during each year. Volatility may not have felt normal in January, but it was – and that’s not necessarily a bad thing. Corrections allow the market to consolidate gains and reign in excess expectations, while giving investors the chance to buy at a discount.
Indeed, this year’s drop was driven by several factors that ended up being overblown. Investors were shaken about rising interest rates, but rates moderated just a few weeks later. They were concerned about the new head of the Federal Reserve, but that transition also ended up being moderate. And they were worried about the implosion of leveraged derivative funds, yet many of the funds that contributed to the decline were quickly wound down. The largest of these, the VelocityShares Daily Inverse VIX Short-Term exchange-traded note (XIV), ceased trading on February 20 after falling more than 90% in one day.
During all of this, the market’s fundamentals didn’t change. The TED spread, global gross domestic product figures and corporate earnings represent three data points that, looked at together, offer a clear picture of the market during a decline. The TED spread is the difference between the interest rate on interbank loans and short-term U.S. government debt. That difference measures the estimated risk banks pose to each other. When the spread widens, it's an indicator of economic deterioration (and vice versa). So far in 2018, the TED spread has widened from 32 to 45 basis points. But the current spread is still below the long-term average of 57 and is significantly lower than its 2008 peak.