Stock Market Volatility: Schwab’s Quick Take
Inflation and recession concerns continued to batter U.S. stocks, which ended a volatile week with a stumble Friday that briefly left the S&P 500® Index in bear market territory. Only a modest late-in-the-day recovery led by more defensive parts of the market pulled the broad-based index back above the 20% border separating a bear market from a severe correction.
Disappointing earnings reports from several big box retailers earlier in the week had pushed stocks to the brink of a bear market, though investors have been fretting about rising prices, high fuel costs, and the future course of interest rates for months.
What started earlier this year with weakness among the more speculative pockets of the market has now spread more broadly. While the S&P 500 managed to avoid falling into a bear market this week, that headline performance still masks areas of acute weakness. The average stock in the index has suffered a maximum drawdown of 25% for the year. Meanwhile, on the tech-focused NASDAQ and small-company-oriented Russell 2000, the average stock’s drawdown has been nearly 40%.
Even with so many of the key stock market benchmarks either near or in a bear market, it’s worth noting that the conditions behind the current bout of weakness haven’t changed significantly this week. While we do see the risk of recession growing, stocks don’t necessarily face different risks once they have met the technical definition of a bear market. As always, having an investing plan in place that takes account of your goals and risk tolerance, paired with an appropriate portfolio allocation, can be reassuring even the dourest of markets. Being prepared for bad markets can make it easier to cope with them.
U.S. stocks: Volatility Likely to Persist
- Investors appear increasingly concerned the Federal Reserve will have a hard time containing inflation without hurting economic growth. We expect its aggressive stance toward prices to lead to more volatility this year. Stock prices already reflect some economic weakness, but they likely haven’t priced in the possibility of a recession.
- We also expect sector leadership to be volatile and recommend investors take a sector-neutral approach to investing. They should focus on high-quality factors such as strong balance sheets, high free-cash-flow yield, and positive forward earnings revisions.
- Investors should also avoid riskier assets and rebalance periodically to keep their portfolios in line with their strategic allocations.
Bonds: Yields fall
- Treasury yields fell as investors sought refuge from riskier parts of the market. The 10-year Treasury yield dropped below 2.8%, after rising as high as 3.2% earlier this month. Short-term yields rose, given expectations the Federal Reserve will raise interest rates by half-percentage-increments at its next few meetings.
- The downside in yields may be relatively limited until inflation comes down. While stock market volatility could lead to more so-called safe-haven demand for bonds, the likelihood the Fed will aggressively raise rates through the remainder of the year, combined with historically high levels of inflation, should prevent yields from falling too low.
- We suggest investors focus on higher-credit-quality bonds like Treasuries, certificates of deposit (CDs), and investment-grade municipal and corporate bonds. CD rates have generally risen this year along with Treasury yields and tend to offer better yields. We’re cautious on high-yield bonds and bank loans given corporate profit concerns, as well as the impact of climbing interest rates on corporate borrowing costs and access to credit.
- Fed officials have generally shrugged off the stock market volatility as the committee is committed to bringing down inflation. Fed Chairman Jerome Powell has said the bank needs to see clear and convincing evidence that inflation is retreating before it can slow the pace of hikes.
- The Fed funds rate is expected to rise to 2.75% by year-end. Expectations for the “terminal” Fed funds rate are now near 3%, down from roughly 3.4% earlier this month.
- Short-term borrowing costs may rise as the Fed hikes rates. Home equity loans, adjustable-rate mortgages (ARMs), and auto loans are often tied to short-term interest rates.
Global stocks: Outperforming
- International stocks outperformed this week, both month-to-date and year-to-date. Among developed markets, inflation in the U.S. is the most stretched, which could result in the need for more aggressive tightening to tame demand. That could weigh on economic growth.
- China is zigging while others zag, with its central bank enacting a larger-than-expected rate cut last night. China may have slipped into recession in April, but the economy could get relief from government stimulus and the potential loosening of its strict COVID lockdowns.
- Global inflation may be peaking, but at a high level. It may take a while for price gains to slow to rates below the longer-term average.
Trading takeaways: Volatility is likely to continue
- Technicals remain bearish. The S&P 500, Dow Jones Industrial Average and Nasdaq Composite notched fresh 52-week intraday lows on Friday before recovering slightly. The S&P 500 briefly entered bear market territory, while the Dow Jones Transportation Average breached the key support level of 14,000 this week and hit a 52-week intraday low on Friday.
- Volatility remains elevated. The Cboe Volatility Index, or VIX, closed just below 30 Friday. At its current level, the VIX implies daily moves in the S&P 500 of 60 points in either direction.
- Given current volatility expectations, option premiums are historically high, making downside risk protection relatively expensive. Traders should consider offsetting hedging expenses by employing multi-leg strategies, such as collars or vertical spreads.
- Equity traders should consider reducing their average share and dollar amounts per trade. While equities could experience sharp bounce-backs at any time, large downside moves may be just as likely. With the major indexes in or nearing bear markets, the risk of margin maintenance calls increases accordingly.
What should long-term investors do now?
Market volatility is unsettling, but historically not unusual. If you’ve built an appropriately diversified portfolio that matches your time horizon and risk tolerance, it’s likely the recent market drop will be a mere blip in your long-term investing plan.
However, it can be hard to do nothing when markets are rough. Given what has been happening recently, consider a few of our investing principles:
- Don’t try to time the markets. It’s nearly impossible. Time in the market is what matters. While staying the course and continuing to invest even when markets dip may be hard on your nerves, it can be healthier for your portfolio and can result in greater accumulated wealth over time.
- Maintain a diversified portfolio based on your tolerance for risk. It’s important to know your comfort level with temporary losses. Sometimes a market drop serves as a wake-up call that you’re not as comfortable with losses as you thought you were, or that a portfolio you assumed was appropriately diversified in fact isn’t. Schwab clients can log in and use the Schwab Portfolio Checkup tool to quickly assess whether their portfolio is still in balance with their target asset allocation. If you’re not a client, or haven’t yet established an investment plan, our investor profile questionnaire can help you determine your profile and match it to an appropriate target asset allocation.
- Rebalance your portfolio regularly. Market changes can skew your allocation from its original target. Over time, assets that have gained in value will account for more of your portfolio, while those that have declined will account for less. Rebalancing means selling positions that have become overweight in relation to the rest of your portfolio, and moving the proceeds to positions that have become underweight. It’s a good idea to do this at regular intervals. Schwab clients can log in and use the Schwab Portfolio Checkup tool to identify areas of their portfolio that may have drifted away from their target asset allocation.
- Build in protection against significant losses. Modest temporary losses are one thing, but recovery from significant losses can take years. Traditionally defensive asset classes, such as cash investments and short-term bonds, tend to perform better when stocks are down. When used for diversification, they can help buffer a portfolio against the effects of up-and-down markets. You’ll also want to consider defensive assets for shorter-term goals or accounts from which you expect to draw money within the next few years.