Stocks are making all-time high after all-time high. Any retreats tend to be short-lived affairs, with equities rarely dipping more far from their elevated perch. Volatility is almost non-existent. Cautious investors might wonder: is 2017 too good to be true?
Worrying about the lack of worry has been one of the main themes in financial markets in 2017, but is such concern warranted? How abnormal is the current market environment? Is it true to say that "history suggests that stock markets always rally strongly before a crash", as the Telegraph put it recently? Or should investors learn to stop worrying and love the bull?
All-time highs
After peaking in 2000, the US market didn’t hit another new high until 2013. Investors who managed to endure that 13-year wait have since been rewarded for their patience, with the S&P 500 making more than 150 new highs over the last four years.
Non-US markets took longer to join the party, but the MSCI World Index has hit multiple new highs this year, following a "dizzying ascent" that has "unnerved City analysts", to quote the Telegraph again.
However, it’s misguided to worry that a correction is looming simply because stocks are registering new highs. After all, any asset with a positive expected return will rise over time. Stock markets typically rise over long periods of time, so by definition they will frequently be trading at new highs.
How frequent? Since 1926, the S&P 500 has hit new highs in almost one-third of all months.
“A market index being at an all-time high generally does not provide actionable information for investors,” says global investment manager Dimensional Fund Advisors. Since 1970, annual global equity returns have been as likely to be positive after a new monthly high as they have after any index level.
Still, US stocks, in particular, have been hitting an unusually high number of new highs this year; could this be indicative of late-cycle behaviour? Not really, says CFRA Research's Sam Stovall, who notes that new highs tend to occur in clusters.
Stocks hit 371 new highs between 1954 and 1968, having gone nowhere over the previous quarter of a century. They hit 504 new highs between 1980 and 2000, having been conspicuous by their absence between 1968 and 1979. There were next to no new highs between 2000 and 2013, but another cycle has been under way since then, with history indicating they are unlikely to dry up any time soon.
Vanishing volatility
Those who are suspicious of the ongoing global bull market see it as an abnormally calm affair. It’s hard to deny that things have been abnormally quiet. The Vix, Wall Street’s so-called fear index, is at its lowest levels in quarter of a century. It recently closed below 10 – just half of its long-term average – for a record five consecutive days.
“Some argue that the lack of fear is so striking that we should be feeling … fearful,” notes Blackrock in its recent mid-year global investment outlook. “Low volatility breeds complacency, the story goes. Sooner or later, volatility reverts to more ‘normal’ levels – with spikes blowing up trades predicated on ever-low volatility.”
Bears note the last year that saw a sub-10 Vix reading was in 2007, prior to the outbreak of the global financial crisis. However, one should be careful of assuming a low Vix is invariably a case of the calm before the storm. The lowest Vix readings in history occurred in 1993, prior to six further years of stock market gains. Volatility was also similar to today’s levels in the early 1950s and mid-1960s, notes Blackrock.
“Low volatility is surprisingly persistent,” says Blackrock. Markets are “typically either in a low or high-volatility state”, with “long stretches of calm punctuated by brief moments of crisis”.
In fact, Sam Stovall’s data suggests that instead of worrying about low volatility, investors should cheer the current calm.
Stovall found 17 previous years where stocks were both unusually strong and unusually quiet. Stocks rose in each of those 17 years, with gains twice that seen in normal years, suggesting the 2017 bull market is not going to peter out any time soon.
Similarly, Stovall notes the S&P 500 has only experienced a handful of days this year where it rose or fell by at least 1 per cent or more. Historically, that has indicated a very high likelihood of annual equity market gains, with stocks typically posting double-digit percentage gains.
In contrast, markets have fallen in roughly two-thirds of years where daily 1 per cent moves were especially common.
In short, history indicates the ongoing angst about abnormally low volatility is misplaced.
Time for a pullback?
The aforementioned evidence indicates investors should cheer, not fear, all-time highs and low volatility. However, that’s not to say that markets will not suffer short-term retreats.
Thus far, there have been precious few such retreats in 2017. In the first half of the year, the S&P was never more than 2.8 per cent off its high (the second-smallest first-half pullback in history); Europe-wide indices have yet to fall by more than 4 per cent; the biggest pullback in pan-Asian indices has been just 2 per cent.
This is an oddly long period of calm. US stocks have not experienced a 5 per cent pullback since June 2016's Brexit vote, the longest such run in 21 years. In the US, stocks have historically experience an average intra-year decline of 14 per cent; in Europe and Asia, the corresponding figures are 16 and 20 per cent, respectively.
In other words, investors have had it easy in what has been "one of the most sleepy markets in history", as LPL Research strategist Ryan Detrick noted recently.
No one can say for sure when this will change, but Detrick would not be surprised if stocks pulled back in August or September, a seasonally weak period for stocks. One potential trigger is earnings season. Most valuation metrics indicate US stocks are pricey, so equities are vulnerable in the event earnings do not live up to expectations. That might unnerve investors who have forgotten stocks are meant to decline on occasions, although Detrick reckons any pullback will not prove to be especially bruising, with stocks ultimately likely to finish the year higher than they are now.
History supports that contention. Bespoke Investment Group data shows that in the past, years that saw small peak-to-trough declines in the first half of the year tended to remain calm in the second half of the year.
History is an imprecise guide to future market action, of course, and all kinds of unforeseen events could throw stocks off course. Nevertheless, the fundamental factors driving stocks higher in 2017 – namely improving global earnings and accommodative central banks – remain in place.
As for the notion things may be a little too good at the moment, the data doesn’t support that conclusion; rather, it indicates calm, strong markets can remain calm and strong for longer than one might think.
