Guy Foster, Brewin Dolphin’s Head of Research, looks at why stock markets rise and fall.
The stock market suffered a few bouts of elevated volatility in 2018. This is most striking because it follows a year in which stock market volatility clocked a historic low level. With that in mind it seems prescient to consider what stock market volatility means for investors in general, and specifically whether recent bouts of volatility pose any more ominous signals.
If you define volatility as the variation in prices, then most investors would have to consider it their friend. If company share prices didn’t change, they would not be able to reflect the improved economic performance of their issuers. But when we use the term volatility we really mean increases in volatility, when shares are more volatile than normal. When that happens it is usually bad news. An investors proverb says that bulls climb the stairs while bears jump out the windows. What this tells you is that share price movements tend to be frequent and relatively modest upward movements punctuated by bursts of sharper downward movements. The abruptness of falls can play on the emotions of investors and lead to calamitous outcomes.
Where did volatility go? Why is it back?
The action of central banks stimulating the economy through quantitative easing suppressed volatility. It meant there was a lot of money around to buy the market on dips preventing the bears from ever getting more than a foot out of the window. Now that markets need to compete for investment we expect to see more ebbing and flowing, or volatility. This may seem unusual in the context of the last couple of years but over the fullness of stock exchange history it is not unusual.
Although the Federal Reserve and the Bank of England have employed QE in the past it was the European Central Bank and Bank of Japan that were printing the most money during 2017.
Of these two central banks the European Central Bank stopped printing new money at the end of 2018 while the Bank of Japan has reduced the amount of money it has been printing and the Federal Reserve has been unwinding its quantitative easing programme. The combination of these actions leaves the market more sensitive to changes in sentiment than it had been in 2017.
What the implications of a rise in volatility?
Benjamin Graham, an investor of almost messianic status used to describe the market as a voting machine in the short term and a weighing machine in the longer term. What he meant was that prices will fluctuate according to sentiment in the short term, but in the long term they will gravitate towards their fundamental value (their weight). The fundamental value being a reflection of the profits a company is expected to make. His message was that value is far more stable than the prices of shares.
Volatility is often used by financial industry professionals as a measure of risk when holding a company share, but that differs from most people’s more intuitive understanding of risk - that is the risk of losing money. If a company’s share price grossly overstates its potential profitability, then it is a risky investment. If it falls because its profitability is falling, then it is a probably a risky investment. If a company’s share price falls, along with all other shares prices, because of a change in the monetary policy of some central banks, then as long as you remain confident in the profitability of the underlying business, that volatility reflects nothing more than an opportunity for gain when the price eventually reverts to it underlying value.
Unfortunately, this rather trivialises the issue of assessing the fundamental valuation of a company. The reality is that assessment is difficult and time consuming but that is why we employ a team of analysts.
Part of the cycle
What we can say about the broader stock market is that for the vast majority of markets, objective measures of valuation look attractive. The CAPE (cyclically adjusted price earnings) ratio, made famous by Yale economist Robert Shiller but inspired by Benjamin Graham for the UK market is around 14 times. Historically when the CAPE has been at that level the subsequent returns from UK equities have averaged 10% a year, after inflation, over the following decade. Similar valuations can be found in all other regions with the possible exception of the United States. Here the CAPE is around 28 times. That is a level which has historically been associated with much lower returns of around 5% per year, after inflation.
The higher CAPE valuation of the US market reflects the fact that it has some well known fast growing, predominantly technology, companies that themselves are particularly highly valued. The risks of these companies are definitely higher on this objective measure than those of other markets, but really you need to look at the individual companies concerned to determine whether they can be justified. To put them in context, the CAPE of the US market in the late 1990s during the infamous technology bubble, was propelled to about 44 times, leading to a decade of negative returns for investors who blindly bought the index.
Blindly buying the market is what a lot of investors were doing at the time. As the market raced away they became frustrated with investment managers who simply couldn’t believe that the prices of stocks were justified, and whose reluctance to hold the most egregiously overvalued caused them to suffer underperformance. But crucially there were bargains available, even at the peak of that bull market, for those who remained laser focused on paying a price which is reflective of the underlying profitability of the company.
The implications for charity investors
Since interest rates have been very low for a decade, many charities have either invested in the stock market for the first time, or have committed additional funds to the market. They have done so both because they need to preserve the ‘real’ purchasing power of the money, after inflation, and because they depend upon the income generated from their investment to fund their services or grants programme. We know from our own research (What Matters Most, 2017), that income is the imperative for many. Anecdotally, our charity clients understand well the need to stomach volatility given the need for growth and income. Most are very long-term organisations and, as such, they can ride out the volatility outlined above. They do so by discussing regularly with their fund managers their time horizon and other aspects of their plans and policy and the way that their investment portfolio is managed. As many commentators remind us, risks can not be avoided, it is understanding what they are and how they are being managed that matters.