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volatility Archives | R | W Investment Management

Elections matter, but not so much to your investments

Election years can be fraught with uncertainty as developments surrounding the candidates, their platforms, and their predicted effects on the economy and markets dominate the news. But should this stream of political information influence how we manage your investment portfolio?

A lengthy history of empirical research suggests not.

Elections matter, just not in all the ways you might think to an investor. Of course, they hold great importance in upholding the U.S. tradition of democratic, representative government. However, their impact on market returns has historically proven to be negligible, as shown in the chart below.

Comparing election years versus nonelection years:

60% stock/40% bond portfolio returns show no significant statistical difference.

 

Given the horse-race nature of political campaigns, you may think that in the months closest to an election, there is a noticeable uptick in volatility. Think again. In actuality, the opposite has been true. From January 1, 1964, to December 31, 2019, the Standard & Poor’s 500 Index’s annualized volatility was 13.8% in the 100 days both before and after a presidential election, which was lower than the 15.7% annualized volatility for the full time period.

Volatility and the vote: Markets tend to ignore elections.

Annualized S&P 500 Index volatility

Full time period: 15.7%

The bottom line: Elections are another one of those events that generate lots of headlines but that should not sway you from following the financial plan we created. It’s understandable to have concerns about the election. But as far as your portfolio and the markets are concerned, history suggests it will be a nonissue.

Part of successful investing is understanding what you can control, and letting your emotions take a backseat to the financial plan we put in place. By maintaining perspective, discipline, and a long-term outlook, you can sustain progress toward your financial goals, despite the short-run uncertainty that events such as elections can create.

Source: Vanguard calculations, based on data from Global Financial Data as of December 31, 2019. Data represents the 60% GFD US-100 Index and 40% GFD US Bond Index, as calculated by historical data provider Global Financial Data. The GFD US-100 Index includes the top 25 companies from 1825 to 1850, the top 50 companies from 1850 to 1900, and the top 100 companies by capitalization from 1900 to the present. In January  of each year, the largest companies in the United States are ranked by capitalization, and the largest companies are chosen to be part of the index for that year. The next year, a new list is created and it is chain-linked to the previous year’s index. The index is capitalization-weighted, and both price and return indices are calculated. The GFD US Bond Index uses the U.S. government bond closest to a 10-year maturity without exceeding 10 years from 1786 until 1941 and the Federal Reserve’s 10-year constant maturity yield beginning in 1941. Each month, changes in the price of the underlying bond are calculated to determine any capital gain or loss. The index assumes a laddered portfolio that pays interest on a monthly basis. All returns assume dividends/interest coupons are reinvested into their respective indexes. Average returns are geometric mean.
Note: Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Source: Vanguard calculations of S&P 500 Index daily return volatility from January 1, 1964, through December 31, 2019, based on data from Thomson Reuters.
Note: Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes:  All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Diversification does not ensure a profit or protect against a loss. Investments in bonds are subject to interest rate, credit, and inflation risk.
Investment Products: Not a Deposit • Not FDIC Insured • Not Guaranteed by the Bank • May Lose Value • Not Insured by Any Federal Government Agency

Volatility is Back

It’s back! Volatility has returned to the financial markets.

The year got off to a calm start, but the stock market saw a return to larger daily price moves. Such volatility has many investors moving more funds to bonds or cash. Sounds reasonable! But economic conditions still favor stocks.

The primary way to measure risk, or uncertainty, in stocks and other financial instruments is to look at option contracts. These risk measurements are generally spoken of on Wall Street as Fear Indices.

The most famous is called the VIX.   The CBOE Market Volatility (VIX) is an index of stock option trading for the large, US-based companies in the Standard and Poor’s 500 Index. The VIX index reflects the cost of hedging risk through the sale or purchase of option contracts on the stocks of US companies. Option prices rise when the underlying stock prices move dramatically in one direction or another – reflecting greater uncertainty over what the price will be in the future.

As of the middle of March, The Chicago Board Options Exchange’s VIX index is at 17 percent, compared to an average daily rate of only 11 percent for all of 2017.  Statistically, this is a big difference. A 6 point rise reflects a large rise in expected risk.

The 17 percent value of the VIX index is a statistical measure called standard deviation. The VIX is saying over the foreseeable future we can expect to see stock returns deviate from their long run average by approximately 17 percent on an annualized basis. In terms of probability, a 17 percent deviation means there is about a 1-in-4 chance investors will be down over the course of the next year.

Therefore, stocks look more risky this year than last. But this rise in uncertainty comes at a time when things look very good in the real economy.

The three main indicators of our macro economy – income, prices, and employment – are all showing improvement. The nation’s income, or real gross domestic product (real GDP), is growing at a 2.5 percent annual rate based on the most recent report. This compares to only 1.5 percent growth in 2016.

According to the Congressional Budget Office (CBO), the US economy is now operating at its potential, meaning we are using all our workers and all our capital equipment fully. In theory, this means prices of goods and services should be rising more quickly.

The inflation rate, however, remains below long-run averages. As measured by the Consumer Price Index (CPI) index, inflation today is 2.3 percent, compared to an annual average of 3.3 percent since the 1980s.

Meanwhile, the labor market is strong. The national unemployment rate stands at only 4.1 percent, below the 4.7 percent rate which the CBO estimates to be normal.

If the economy is doing well why should stock prices be any more volatile? What’s the risk?

The financial market uncertainty seems to center on the fiscal and monetary policy of governments around the world.  What policies are changing that will hurt corporate profits and stock prices?

In terms of fiscal policy, most developed nations continue deficit spending, raising government debt levels. For monetary policy, central banks continue to hold bank interest rates below historical averages.

The US public debt situation is unchanged with total federal debt holding at just over 100 percent of GDP.  The debt levels of other major governments are growing even more (e.g., Japan).

Central banks around the world continue to support such government borrowing with relatively easy monetary policies, or liquidity in the banking system. High bank liquidity keeps interest rates below market equilibriums and creates uncertainty over the consequences of how fast central banks may raise rates.

Fortunately, classical economic theory and historical evidence show us that these two situations should not concern us. First, economist David Ricardo (1772 – 1823) showed when people expect taxes to be raised to offset the future payments of principal and interest on current debt, then today’s debt financing is equivalent to a tax.

That means there is no real difference if the government taxes its citizens or borrows to finance its spending. Thus, rising government debt levels shouldn’t affect corporate profits any more than current taxes. Companies have made good money even when governments run deficits.

Second, economist and philosopher David Hume (1711 – 1776) showed monetary policy has no real effect on the economy. Monetary neutrality is the theory that over time changes in the level of bank money and credit affects only nominal variables, such as interest rates and exchange rates. Such changes have no effect, however, on real variables like income and consumption.

Therefore, banks and other financial institutions may be at risk as interest rates rise, but most companies will see no harm. Households will even benefit from better returns on their savings.

With interest rates still below normal and the underlying economy humming along, stocks remain the better value over bonds or cash despite rising uncertainty. The near-term outlook for increasing household incomes and corporate profits remains strong.

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or R|W Investment Management.

 

Peter R. Crabb, Ph.D.

Professor of Finance and Economics

Department of Business and Economics

School of Business, Northwest Nazarene University

 

[email protected]

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado.  His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others.  Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

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