Pennsylvania Trust

Volatility Returns (as forecast)

Photo of George McFarland

Fueled by a strengthening global economy and strong domestic corporate earnings growth, the S&P 500 posted a 5.6% total return in January, its 11th best January advance since 1950, according to Strategas Research. Of note, the S&P 500 logged 14 record-high closing levels during the month.

Coming on the heels of a very strong performance in 2017, with the S&P 500 up over 21%, January’s torrid gains left the market extended and ripe for a pullback. Last week saw such a pullback occur.

The culprits for the pullback were rising interest rates and fears of rising inflation rates. These fears became more pronounced last Friday with the release of January payroll data. Among other things, the payroll data showed that private sector wages grew by 2.9% in January on a year over year basis, the fastest average hourly earnings growth since 2009. While this level of wage growth is still below the long-term average, it stoked worries that overall inflation might rise past desired levels in the future. This resulted in a bond market sell off, with the 10-year U.S. Treasury yield rising to 2.84%, its highest level since January 2014. Inflation worries also caused the stock market to sell off, as fears rose that inflation could cut into corporate profits, and that the Federal Reserve might need to raise interest rates more than expected, which could slow economic growth.

With today’s market decline, the S&P 500 now rests about 7% off of its recent highs. While this current decline may well have farther to go, we would not fear this pullback but instead, would regard it as a normal, healthy development that likely will lead to renewed gains in the weeks ahead. After all, the economic underpinnings to the market rally have not changed, and the near-term chances of recession remain very low.

As we forecast in our 2018 investment outlook, volatility (both up and down) has increased this year, and likely will become more pronounced in the quarters to come. Indeed, today the VIX (an S&P 500 volatility index) hit levels not seen since August 2015. Nonetheless, with a positive January, the odds of a positive full year are around 80%, based upon history. Indeed, in each of the ten years since 1950 where the S&P 500’s January performance was better than January 2018, the S&P 500 ended the year with gains, and in all but one of those years, with double-digit gains…this despite the fact that each such year saw a median intra-year decline of -8%.

The bottom-line is respect, but do not fear, the current decline. Even our own Philadelphia Eagles’ Super Bowl victory supports this forecast. According to the Wall Street Journal, “Stocks go up for the year if an original National Football League team (like the Philadelphia Eagles) wins.” Another reason to feel good about the Eagles’ historic victory!

Mr. McFarland is President, Chief Executive Officer, and Chief Investment Officer of Pennsylvania Trust.

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