Financial markets have been increasingly volatile as of late and some concerned investors may be wondering whether we should be looking for another, bigger shoe to drop. Market participants have indeed had a lot to chew on over the past few months as pick-your-adventure geopolitical concerns remain in the headlines and a majority of economists continue to suggest there’s nothing to worry about while housing conditions slip and some measures of household confidence have eased.
Who me, worry?
We believe that there are indeed a number of very important developments unfolding that could have a materially negative impact on risk asset performance in the near term and we’ve written about them on this site. What we’re finding is that the impacts of these worries are simply pushing some investors to tap out of the markets.
Our work shows that market resilience surrounding these events has wavered this year, and a key reason being is that it is increasingly difficult to find a positive near-term narrative for investors to hang their hats on. This lower confidence translates to weaker investor conviction to buy when prices go down, which tends to turn what should be a minor market negative into a notable selloff as evident in three key market indicators we’re looking at this week.
First, the CBOE’s VIX index (which measures implied market volatility over the next few months) has been tracking more gyrations in line with what we saw earlier this year when markets were concerned about rising wage growth/inflation and the Fed. These bets on expected volatility have been moving higher this year relative to the past three years, a development more evident in the rolling 6-month average.
Another indicator showing a similar development in its trend is the Put/Call ratio. This indicator tracks the number of puts (derivatives purchased by some market participants to make a bet that the price of a security will go down) over the number of calls (the opposite of a put). A number above 1 suggests that there are more pessimistic than optimistic participants in the market. The data show that this has indeed been the trend with rolling six-month average in the put/call ratio rising to a three year high as of this week’s market close.
Finally, the AAII Investor Sentiment survey is another indicator that we believe is pointing to generally more subdued optimism among individual investors. This survey asks individual investors to indicate whether they are bullish (favorable), bearish (negative) or neutral in terms of their outlook the markets. The latest weekly read through November 15 showed that the number of survey participants responding with a bearish outlook was above average for its sixth straight week.
Putting it all together
Taken together, these three simple data points suggest that sentiment has indeed wavered this year, which is likely contributing to broader and deeper downdrafts when markets turn on negative news developments. Further compounding this problem is the lack of a broad, clearly defined investment thesis to entice investors back into the markets as various indicators suggest the U.S. economy is likely to slow soon and the Fed continues to tighten monetary policy. So how do we think investors should respond?
First, don’t panic. We believe that the falling levels of investor conviction and rising levels of market volatility are consistent with late cycle market conditions. In other words, we believe that while disconcerting, and we expect that markets will increasingly move sideways in the near term, that these developments are a normal part of the market cycle.
Second, get opportunistic when others become fearful. It is under these conditions that we believe investors should be more diligent about ensuring that their investment portfolios are aligned with strategic investment objectives. In other words, rebalance into the market volatility. If a portion of your portfolio has increased in value beyond its intended long-target allocation, we suggest using current market volatility as an opportunity to trim these exposures and add to holdings that are below their long-term investment targets.