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Investors should be Prepared for Bouts of Volatility in the US Market

Nothing seems to be able to phase the stock market recently. Political infighting, Presidential tweets, North Korean missile launches, oil falling below $50, European political uncertainty, higher bond yields, and the Fed raising rates: none of those forces have knocked stocks off their recent uptrend. Volatility has remained remarkably low for an extended period. Remarkably, at this stage of the eight-year bull market (reached on March 9), stock gains have accelerated in recent months while volatility has declined.  

Just when we were starting to get concerned about the potential of a true "melt-up" in U.S. stocks, the indexes trended sideways to slightly lower during the first two weeks in March, allowing the prior gains to be digested, and for sentiment conditions to ease a bit. According to the Ned Davis Research (NDR) Daily Trading Sentiment Composite, investor sentiment moved back into neutral territory recently, easing concerns about a near-term, sentiment-driven pullback. But is this the calm before the storm?

This period of calm isn't going to last forever, and we caution investors to remain disciplined around diversification and rebalancing. Part of the reason for the depressed volatility may be the rise in passive investing—index funds don't move in and out of stocks nearly as much as actively managed funds do. That trend may be reversing, which would likely increase volatility. Additionally, political rancor, foreign election uncertainty, geopolitical tensions, and a more hawkish Federal Reserve all have the chance to contribute to a pullback. We have made a couple of moves in an attempt to allow portfolio gains from stocks to continue, while potentially providing a bit of a buffer against the possibility of an uptick in volatility. We remain overweight to U.S. stocks as we believe the bull market continues, but we recently shifted to a large cap bias. Additionally, on the sector front, we added the health care sector to our outperform ratings, adding the potential of a little defense in a largely cyclically-bullish tactical bent.

Well-deserved confidence?

While there may be pockets of complacency, the recent market run and accompanying higher confidence among business, consumers and investors appears well-founded by economic fundamentals, which supports our belief that the secular bull market has further to run. Confidence spikes have been seen in both the National Federation of Independent Business (NFIB) small business confidence and the Conference Board's consumer confidence indexes. In addition, the forward-looking new order components of both the ISM Manufacturing and Non-Manufacturing Indexes spiked higher in the most recent readings (65.1 and 61.2, respectively—with values above 50 indicating expansion). And the "hard" data is now starting to confirm the "soft" (survey/confidence-based) data. The February retail sales report showed a 0.2% increase, excluding autos and gas, while January's reading was revised higher. The labor market also remains strong, with ADP reporting a surprising 298,000 new jobs in February and the Labor Department reporting 235,000 jobs were added; while the unemployment rate fell to 4.7%.

GDP forecast has come down

We want to caution investors against extrapolating that weakening into the rest of the year, while pointing out that the less-followed NY Fed GDP Nowcast has first quarter growth at 3.2%. Also remember that GDP growth is backward-looking and the stock market is forward looking; which is why leading economic indicators are more valuable "forecasting" tools for the stock market. Most indexes of leading indicators, such as initial jobless claims, show the trajectory remaining decidedly higher.

Fed raises, and signals more to come

Helping to bolster our belief in a strengthening economy—and our bullish stance—is the increased hawkishness of the Federal Reserve and their decision to hike rates at the March Federal Open Market Committee (FOMC) meeting. Additionally, the Fed signaled willingness to continue to hike rates in the coming months, which would mark the first time we would see more than one hike in a year since the financial crisis. Impressively, the market took the rate hike in stride, indicating to us that investors believe the Fed should accelerate the normalization process in keeping with strength in both of the Fed's mandates (jobs and inflation). The most recent consumer price index (CPI) reading, ex-food and energy, was up 2.2% year-over-year (y/y); while average hourly earnings (AHE) from the labor report showed a 2.8% increase y/y. The market may be at risk if the Fed has to significantly accelerate its hiking campaign, but for now, markets are taking it in stride and remain calm.

We continue to believe health care, tax and regulatory reform will occur, but the process may take longer than many investors had been hoping for, which could lead to some volatility in stocks.

So what?

Stocks have been remarkably resilient and calm has permeated the investing landscape; but that doesn’t mean investors should be complacent. Taking profits in outsized positions and maintaining a diversified portfolio are important to being successful long-term investors. Politics, both here and abroad, could contribute to periods of uncertainty among investors, and contribute to times of greater risk aversion. The U.S. bull market should continue, but we also believe volatility will pick up and pullbacks could occur, so remain disciplined.


Important Disclosures

This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Fung Business Intelligence
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