Monday, March 1, 2021
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2 Reasons To Expect Very Volatile Stock Markets

We live in an unprecedented investment environment. Global interest rates are at historically low levels and global debt is at levels that dwarf previous eras. The global pandemic, despite the presence of vaccines, remains uncontrolled. Governments must resort to enormous stimulus measures to support the economy and central banks are expanding the money supply seemingly without limit.

Yet, against this sobering backdrop, global stock markets have risen strongly since the market crash of March 2020. The recent strength of stocks has attracted a new generation of small investors that has helped fuel the market’s rise, which has contributed to a general level of investor optimism not seen since the days of the internet bubble at the turn of the century.

There has never been a greater disconnect between the behaviour of the stock market and the underlying economy in history. What can investors expect going forward? Forecasting the future is always uncertain, but one guesstimate I can make with some confidence is that the months and years ahead are likely going to provide a bumpy ride.

I present two reasons to support my view.

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The chart above depicts the yearly average of the Volatility Index of the S&P 500 (VIX). The Vix is a calculation of expected volatility of the S&P 500 derived from the pricing of options on the S&P 500. The VIX has typically been used as a gauge of investor fear or complacency, with the VIX rising as fear levels increase and falling when investors are more optimistic or complacent.

What is noteworthy about the chart is that the end of 2019 represented the 8th consecutive year that the VIX traded below historical averages. This is important to note because volatility has a strong tendency to revert to the mean. In other words, periods of low volatility will eventually be followed by high volatility to reduce the VIX to historical averages. The very low level of volatility seen in the past decade suggests that the 2020s will be unusually volatile.

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A second reason to believe that the S&P 5500 will be more volatile in the future is the unusually large index weighting that the top 5 companies represent in the index. At the peak of the internet bubble, the top 5 companies represented about 18% of the total index. It is now about 23%, which is the biggest weighting in history.

The large weightings of these 5 large companies increase the potential volatility of the S&P 500, both up and down. These large companies represent the tail that wags the dog, the results of the broader index are highly dependent on this handful of stocks.

This would not be a concern if the stocks continue to perform well. But history suggests otherwise, as the following chart demonstrates.

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The chart above depicts the considerable change in the composition of the top 5 stocks in the S&P 500 over the decades. The fading of previous market leaders, and their replacement, produce volatility. That the current top companies represent the biggest weighting ever suggests that we can expect elevated volatility in the years ahead.

Market volatility, especially sharp declines in the stock market, is disquieting to many investors. It has been, however, a constant presence through history. Stock market volatility reflects the drama of human history. The best that one can do is to expect the vagaries of the markets and arrange our investing activities accordingly.

In conclusion, the unusual volatility that I see ahead for the 2020s will present both great risks and great opportunities for investors. It will be those most prepared who will navigate the years ahead most successfully.

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