The financial markets have experienced unprecedented bouts of volatility over the past few weeks.
There are a plethora of explanations for the massive sell-offs. Some are more complicated than others. In my view, the reason for the increase in volatility is quite simple: fear!
So, why has the fear gauge suddenly jumped? Because investors are anxious about the impact that rising interest rates will have on asset prices. Rising interest rates have been a topic of discussion among financial market participants for some time, so there was some anticipation that this would eventually occur. However, many investors were caught off-guard by the timing and the speed. The fact that interest rate hikes might occur sooner than later has resulted in a stampede of investors out of more risky assets such as stocks and corporate bonds and into safe haven assets such as short-term money market instruments.
Is the shuffle out of stocks justified?
When you look at the fundamentals, it is not unreasonable that a sizeable sell-off has occurred given the high valuations of stock market indexes, especially in the US. The difficulty, as always, was in predicting when this would happen. Moreover, a level of complacency had crept into the market causing investors to become comfortable with high valuations. The other bubbling factor was the dangerous practice of analysts constantly revising forward-earnings upward to justify the current higher valuations.
Nonetheless, the jump in interest rates was a signal to some investors to reduce holdings of stocks. So does the exodus out of stocks make sense? Yes and no. Yes, given that market indexes in aggregate were overvalued. But no, because not every stock in the index is overpriced. So, investors can simply find and hold those stocks which are fundamentally undervalued, as opposed to completely liquidating all stock positions. Additionally, the fact that the monetary authorities are considering further interest rate hikes is a signal that the economy is on strong footing and a good reason to have some stock exposure in your portfolio. GDP is strong, and unemployment and interest rates are low. But headline US inflation - as measured by the consumer price index (CPI) - is starting to trend up, rising 0.5% in January which was more than expected. While the prospect of higher US inflation resulting from low unemployment and aggressive tax cuts is a brewing concern, inflation can be quite positive for certain sectors. In general, holding stocks in your portfolio is a good way to fight inflation.
What should investors do?
It is best to avoid trying to time when to get in and out of the stock market. Instead, take a long-term view with the goal of buying stocks in quality businesses at reasonable prices, one at a time. At any given point, some stocks are undervalued based on the unique merits of the underlying business, and you should focus on holding these businesses in your portfolio. Depending on where we are in the business cycle, it may be easy or difficult to find these opportunities. The best thing you can do to ensure that your portfolio is properly managed to meet your specific retirement goals is to employ the services of a professional portfolio manager who can find the right opportunities for you.