Schwab: Stock Market Volatility
U.S. stocks fell Tuesday, adding to a string of losses from last week and leaving the major stock indexes near or below their lows for the year, as investors reacted to the increasingly fraught picture for earnings and the economy. Disruptions related to the war in Ukraine and the strict COVID lockdowns in China, combined with the Federal Reserve’s increasingly aggressive language about interest rates and inflation, continue to dim the prospects for profits and growth.
Tuesday’s losses were broad-based, with 10 of the 11 industrial sectors tracked by S&P ending lower. The sole outlier was energy, which was little changed from Monday. With its nearly 2.4% drop on Tuesday, the S&P 500® Index is now down about 13% for the year so far.
Markets have grown more volatile as the Fed’s plans for tamping down historically high levels of inflation have evolved in the face of persistent price increases. Markets are now bracing for a half-point increase in May—a much sharper move than the quarter-point hike in March—with more tightening to come later in the year. Expectations are for the Fed’s short-term federal funds rate to hit 3% in early 2023, up from 0.25%–0.5% now.
Schwab’s view is that the risk of recession is rising, and volatility is like to continue. Equity investors should limit their risk-taking and use rebalancing to maintain their strategic allocations.
U.S. stocks: Not all is as it seems
- The mid-March rally in U.S. stocks wasn’t as strong as it appeared, as more-defensive sectors and speculative parts of the market outperformed the more-cyclical sectors we’d expect to see leading a sustained rise in the benchmark indexes.
- Cyclical and growth sectors have been hit the hardest since the end of March. Communication Services, Tech, and Consumer Discretionary have led the S&P 500 lower, while traditional defensives (such Consumer Staples) have done slightly better.
- Sector volatility and a rapid turnover in sector leadership are likely to continue, given all the sources of uncertainty hitting the market. Schwab recommends stock investors stick with a sector-neutral approach for the time being.
Global stocks: Look to the short term
- Central banks around the world are likely to join the Fed in trying to ratchet back inflation, as a strong global economy continues to put upward pressure on prices.
- Rising interest rates could favor shorter-duration stocks, which generate more of their cash flows in the near-term rather than the distant future and are more prevalent in international markets. Such stocks have historically outperformed when interest rates are climbing.
- Tangled supply chains may be improving, which could help alleviate some of the pressure from inflation and central bank tightening. We see some positive indications in recent earnings commentary, Taiwanese semiconductor orders, Shanghai container freight rates, as well as trucking rates in the U.S. However, waning demand could be a problem.
Bonds: Higher yields create potential opportunities
- Expectations for a series of Fed rate hikes have caused short-term rates—for maturities of one year or less—to move up sharply. This trend is likely to continue as more rate hikes come.
- Long-term Treasury yields may rise modestly after recent declines, but demand from investors looking for shelter from riskier parts of the market is likely to prevent yields from rising significantly higher. We believe the worst of the rise in yields is behind us.
- Higher yields have created potential opportunities for fixed income investors, who can now earn better yields than we’ve seen in three years. We still suggest investors focus on higher credit quality bonds, such as Treasuries and investment grade municipal and corporate bonds, as riskier segments of the market typically don’t do as well during tightening cycles.
Trading takeaways: Volatility is likely to continue
- Major indexes are now below key technical levels: The Nasdaq Composite index closed at a 52-week low Tuesday. The Russell 2000 closed at its lowest level since December 2020. It is also below the key support level of 1,900, which it had tested multiple times this year.
- Volatility remains elevated. The Cboe Volatility Index (VIX) is up more 50% from less than a week ago and closed above the key 30 level for the first time since March 14. At the current level of 33, the VIX is implying daily moves in the S&P 500 index of 73 points in either direction.
- Equity traders should consider shrinking the size of their trades. Sharp bounces higher are just as plausible as large moves lower in the near term.
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 dipmay be hard on your nerves, it can be healthier for your portfolio and can result in greater accumulated wealth over time.
- Build 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.