BLOG: Why investors should embrace market volatility

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Written by:
27/08/2014
JP Morgan's Andy Goldberg on why a little volatility is a good thing.
BLOG: Why investors should embrace market volatility

Congenital insensitivity to pain is a rare and dangerous disorder that causes those afflicted by it to quite literally feel no pain. This happens because of a genetic malfunction that prevents ‘pain signals’ from being transmitted to the brain. At first this may sound pretty appealing, but a moment of consideration soon reveals the pitfalls of such a condition. Young children diagnosed with this affliction have been known to chew their own tongue whilst teething or break a limb without realizing it.

It is ‘pain signals’ in the markets that keep investors from unknowingly walking off a stock market cliff like they did in 1999-2000. Today, we need to be paying particular attention to what these indicators are trying to tell us.

In response to the trauma of the 2008/9 financial crisis, global central banks administered a heavy dose of medicine to help the global economy stabilise and heal. Trillions of dollars and pounds were printed and injected into the banking system (in the form of quantitative easing) to shore up lenders, whilst interest rates were lowered to near-zero to encourage people and businesses to borrow money.

Despite a rocky launch, the recovery is now five years old and the UK and US economies are both being held up as a model of success. Markets have also responded, with the S&P 500 Index some 200 per cent higher than its 2009 crisis lows and the FTSE 100 is just a little behind.

But after such a strong run, many have come to worry that markets – and investors – have lost their sense of reality and become heedless of the potential pain signals. Are the alarm bells going unheard? Could this be another 1999-2000? Have we become overly complacent, perhaps sedated by the intoxicating drug of monetary easing that has in effect blocked any pain alerts from reaching the brains of investors?

It’s not too difficult to draw up the case that we’re on course for another fall, if the grip of this giant anaesthetic type environment caused by central bank action doesn’t start to wear off. For one, despite a long list of troubles in the geo-political realm (Gaza, Iraq, Ukraine, Syria, Sudan, and others) and angst about slower growth in China, overall market volatility as measured by the VIX Index remains not far from historic lows. It has also been more than 1,000 days since the S&P 500 has experienced a 10 per cent correction – something that has only happened two other times in the last 25 years.

This is the sort of market environment that may be vulnerable to sudden injury.

Fortunately, the last few weeks have begun to see the market slowly waking up from its pain-free slumber. From 24-July to 1-August, the S&P 500 index fell 3.2 per cent and markets in France, Germany and Belgium pulled back more than four per cent. The VIX index rose by 40 per cent, and while it remains at historically low levels, is showing signs that markets are more alert.

There is no doubt that a combination of geo-politics, monetary policy uncertainty and uneven global growth will result in some bumps ahead, but we need those bumps to return to a more healthy normal. For investors, three to 5 per cent pull backs – or even a 10 per cent correction – shouldn’t necessarily be feared, but rather seen as an important check and balance to ensure markets maintain a healthy self-preservation sensitivity to danger.

As the numbness gradually wears off, it may be understandably tempting for investors to now go underweight stocks in a bid to avoid the pain signals altogether. We don’t believe this is the right move for a number of reasons.

First, barring some shock, an expanding global economy (particularly the steadily growing US) should support further gains in corporate earnings, which in turn supports stocks. Second, whilst both inflation and interest rates look set to rise, they should remain low enough over the next few years to support, rather than undermine, stock prices. Third, while no one would claim that stocks are cheap on average, they aren’t expensive either.

Finally, as of right now, neither the US nor the UK economies appear to be particularly threatened by either the geopolitical shocks or economic imbalances that have heralded the end of previous bull markets. Of course this could change, but for now, a modest preference for stocks still makes sense in the context of an appropriately balanced portfolio.

As the extreme central bank policies that have kept markets comfortably numb in the past few years begin to recede, there is no escape for a return to pain as the medicinal haze recedes. But investors would be well served to keep in mind that it’s better to suffer through some short-term aches on the road to recovery and normality rather than remain forever on the verge of a trip to the emergency ward.

Andy Goldberg is global market strategist at JP Morgan Asset Management.

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