A rare calm has settled over the stock market. Whether it turns out to be the one before the storm is a compelling question after a year of conditions so placid that investing has begun to look deceptively simple.
In all of 2017, the Standard & Poor’s 500-stock index experienced no decline greater than 3 percent, the first time that had happened. And a widely followed volatility index known as the VIX closed below 10 on more than 40 days in a six-month period through late November, according to Citi Research. Before that, the VIX had not closed below 10 on more than six days in any six-month period.
The peaceful trading backdrop helped the S.&.P 500 rise 19.4 percent on the year and 6.1 percent in the fourth quarter. Factoring in dividend payments and additional appreciation from the reinvestment of those dividends in the constituent companies’ stocks, the index returned 6.6 percent in the quarter and 21.7 percent throughout 2017. And, despite some rumblings in the bond market, stocks moved even higher in the early days of 2018.
But the drastically reduced trading volatility, a condition sometimes called metastability, worries some Wall Street strategists.
It’s not just that persistent buying has sent stocks to valuations exceeded only on a few occasions that preceded spectacular plunges. Billions of dollars have been committed to vehicles that seek to profit from the extraordinary degree of stability and depend on it persisting. If and when things change, the storm after the calm could be sudden and violent.
“Increasingly, people of a certain age who have seen enough cycles say, ‘We’ve been here before. We know the party’s going to end,’” said Rebecca Patterson, chief investment officer of Bessemer Trust, a firm that advises wealthy families. “It won’t end well.”
The year ended well for domestic stock funds, with the average one in Morningstar’s database gaining 5 percent in the fourth quarter and 18.3 percent on the year. Portfolios that focus on technology, natural resources and economically sensitive consumer issues were especially strong in the quarter. Health care and real estate funds were noticeably weaker.
A stock market that never goes down except by a negligible amount — at least lately — has been widely perceived as less risky. Vehicles known as risk-parity funds seek to capitalize on the lack of price swings by allocating more money to stocks as volatility diminishes. Mutual funds that employ risk-parity strategies held about $8.6 billion at the end of 2017, according to Morningstar.
But nothing lasts forever. When the metastability ends and volatility returns to more normal levels, risk-parity funds will view stocks as riskier and begin to take their bets off the table. The more sudden the return of volatility, the faster the funds will sell. If it happens quickly enough, the market could go from metastable to not at all stable, turning a virtuous circle vicious.
“The whole thing could unravel very quickly,” Ms. Patterson said, although she is merely concerned, not alarmed.
“We don’t see enough red flashing lights to get out,” she said, “but we see yellow caution lights.”
For Komal Sri-Kumar, president of Sri-Kumar Global Strategies, the hue is more crimson.
“I see risk preference shifting significantly to risk taking,” he said. “The low-volatility trade is characteristic of a euphoric market.”
But, he added, “There are uncertainties present in global markets, and investors are also ignoring how highly valued equities are. They don’t seem to care. In terms of what the equity market is telling you, they have no concern that a problem or a massive correction lies ahead. They think central banks will save them.”
The bond market is sending a more unsettling message, Mr. Sri-Kumar warned. Despite steady and stronger economic growth in recent quarters and low unemployment, yields on long-term Treasury securities haven’t risen very much, even as short-term rates continue higher. That combination has led the yield curve, or the difference between short and long rates, to flatten.
The yield on two-year Treasury issues at the end of December was 0.51 percentage points below 10-year Treasury yields, close to the narrowest spread in 10 years. The spread has widened slightly but if the yield curve should invert, pushing short-term rates above long-term ones, it would be an ominous sign, because an inverted curve often heralds a recession.
“It’s very instructive that the bond market is giving a completely opposite story,” Mr. Sri-Kumar said. “It has gone from being somewhat cautious to excessively cautious. I think it will invert over the next few months.”
The average bond fund rose 0.5 percent in the fourth quarter and 4.8 percent on the year.
“The fixed-income rally still has a way to run,” Mr. Sri-Kumar predicted. “If we do have a massive stock market correction, we will see the 10-year Treasury and investment-grade bonds going down in yield.”
He would reduce holdings of stocks and focus on defensive sectors and foreign markets, and he would allocate as much as 20 percent of a portfolio to cash.
The low volatility and overvaluation in the stock market have lasted a long time and might do so until a catalyst arises. That could be the continuing shift in Federal Reserve policy that kept short-term interest rates close to zero percent for nine years and led the central bank to buy trillions of dollars of bonds in its quantitative easing program.
The Fed has already raised rates five times in the last two years, including in December, and it announced in September that it would begin selling the bonds in its enormous inventory. The impact of such changes on the markets could depend on what investors focus on: how much support the Fed continues to provide, or how quickly it is removing support.
James Paulsen, chief investment strategist at the Leuthold Group, cautioned in a note to clients that while economic conditions may seem close to ideal, small changes could threaten that benign outlook.
“Perhaps we are in the early stages of a melt-up similar to the late stages of past bull markets,” Mr. Paulsen wrote. “However, several economic and financial market indicators are on the cusp of eye-catching levels, which could shatter the ‘sweet spot’ scenario.” Long-term Treasury yields in early December were 0.25 percentage points below three-and-a-half-year highs, for instance; wage and consumer price inflation were near multiyear highs; and unemployment was a couple of tenths of a percentage point from 50-year lows.
One recent development that caught the eyes of investors was the most sweeping overhaul of the federal tax code since the 1980s, including a drastic reduction in corporate income tax rates. But there are other matters of policy and politics that could send stocks lower if a more aggressive Fed does not.
Mr. Sri-Kumar advised investors to “watch for a possible cancellation of Nafta in the first quarter.” If the North American Free Trade Agreement is torn up, American multinationals may face retaliation abroad.
“The rising risk of a trade war will be a more important factor to consider for 2018 than any positive impact of the corporate tax cut,” he said.
Concern that American stocks may be expensive and accident-prone is sending some investors packing. Foreign stocks comfortably outpaced their American counterparts during 2017 when returns are expressed in dollars.
The SPDR S.&P. 500 exchange-traded fund rose 19.4 percent last year, while iShares MSCI EAFE, which tracks foreign developed markets, rose 23.8 percent, and iShares MSCI Emerging Markets gained 35.2 percent.
The average international stock mutual fund was up 4.5 percent in the fourth quarter and 25.9 percent for the year. Specialists in China and India rose more than 40 percent on average for 2017.
The comparative strength overseas “has probably got to do with the starting points in terms of valuations and interest rates,” said Benjamin Beneche, one of the managers of the AMG Managers Pictet International fund. American stocks are so expensive that, even with the recent underperformance, they remain considerably more expensive than foreign shares.
At the end of the year, the S.&P. 500 E.T.F. traded at 22.7 times the earnings of the constituent companies over the preceding 12 months, according to Morningstar. Valuations were 17.5 times earnings for the EAFE fund and 14.4 times for the emerging markets E.T.F.
Jeremy Richardson, a portfolio manager at RBC Global Asset Management, attributed the strength abroad to evidence that President Xi Jinping was consolidating power in China; recent increases in commodity prices, which help the many emerging economies that export them; and “a firming of economic growth, in Europe in particular, amid some signs of central bank and fiscal policy taking hold.”
His advice for investors scouting around for foreign assets is “to emphasize equities because they’re better in the long run” and “to pay close attention to the quality of companies you’re buying.”
Mr. Richardson finds particularly good opportunities in cloud computing, where “the size of the market is underappreciated by most investors,” and businesses related to electric transportation, such as battery and motor manufacturers.
Mr. Beneche likes the auto industry, too, but the old-fashioned one.
“There’s a myopic focus on electric vehicles and ride sharing,” he said. “The electric transition might take longer than people are expecting.” He especially likes companies that make parts for cars already on the road, such as Hyundai Mobis.
Other niches he favors include Asian consumer technology companies like SoftBank, Alibaba and JD.com, a Chinese e-commerce business, and businesses with a large controlling shareholder, such as Vivendi and Richemont.
Ms. Patterson is less sanguine about foreign stocks. She said much of the outperformance has been caused by a weak dollar, which raises the value of foreign assets. She expects the dollar to recover and prefers American stocks, particularly technology issues. Nevertheless, the risks that have lain dormant have persuaded her to remain well diversified in bonds, foreign stocks and gold, which has “kind of been left for dead.”
The stock market has had plenty of life in it, even if trading has not been lively. For Ms. Patterson, “the base case is that Goldilocks continues,” she said, meaning conditions will be just right, with low inflation and benign central bank policies. But with that outlook ubiquitous on Wall Street, as implied in the eerie calm in the stock market, she is reluctant to state her case too strongly.
“The idea that the party will continue for quite a long time is creating more risk-taking, and that’s what worries me more than anything else right now,” she said. “Will this year be more of the same, or will a big bear come out and ruin us?”
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