Is it Time to Welcome Volatility Back into Our Portfolios?

It seems there are plenty of things to blame for September’s nearly 5% stock market decline, the worst monthly performance since last March. It started with a global worries over a possible default by China’s real estate developer behemoth Evergrande. The market continued to convulse over indications of declining energy supplies and was further agitated by a sudden uptick in 10-year Treasury yields. Suddenly, investors are picturing themselves standing on another precipice, looking deep into the abyss.

While you can never rule out another stock market correction, which may be overdue anyway, this is more likely an overreaction to short-term events that will have little if any impact on the economy’s performance or the stock market six to twelve months out. If anything, it was another wake-up call letting investors know that volatility still exists in the stock market, just as it always has. As unnerving as it might be in the moment, investors would do well to remember volatility is how the stock market has generated mostly positive returns over the last 100 years.

More Volatility to Come?

Is there more volatility to come? Probably. October is known as the most volatile month of the year, having spawned some of the stock market’s declines over its history. That aside, having ridden the market to historic highs, investors are going to be super-sensitive to negative news, regardless of how incidental it is to the long-term performance of the economy. For instance, with the help of the media, they made much more out of the events that triggered the volatility in September.

About Those Energy Fears

Consider all the fear over declining energy supplies and the possibility of a global energy supply crunch this winter. The media has been fixated on mile-long gas lines in the UK and the electricity shortages plaguing China—both signs of worse things to come! The media doesn’t tell you that the gas lines in the UK are not the result of a gas supply shortage but rather a shortage of truck drivers to transport the gas. A few temporary closures of gas stations due to no supply quickly ballooned into a run on stations throughout the country. But, gas suppliers are beefing up their transportation with signs the bottleneck is already easing.

In China, the energy shortage, evident through electrical blackouts occurring throughout the country, has been self-inflicted. Coal prices are up sharply in China due to its ban on Australian coal imports. Instead of passing on higher energy costs to consumers, as most utilities do, China has placed a cap on electricity prices. As a result, many of the country’s coal-fired power plants are attempting to curb their steep losses by closing for “maintenance” or operating well below capacity. With an election on the horizon and his stature at stake, it’s not likely President Xi Jinping will allow these electrical shortages to go on much further.

Globally, it appears that energy output is increasing. US oil and gas production is nearly over the Hurricane Ida hump. More shale producers are coming back online, and OPEC is pointing toward production increases. All indications that current supply and demand imbalances are on their way to being corrected.

And Interest Rate Fears

The recent uptick in the ten-year US Treasury yield is causing concern for media pundits predicting a rise in long-term interest rates, which could trigger a stock market decline. However, if they would apply some perspective, they might have to admit that the less than half-point uptick isn’t a big deal, considering that today’s rates are still very low by historical standards. While it’s likely we’ll see further interest rate increases over the next year due to the Fed’s easing off its bond purchases, that’s not necessarily a bad thing. Until now, the flat yield curve has discouraged banks from lending—having to borrow at short-term rates while lending long-term rates, which squeezes their margins. Higher long-term rates would widen the yield curve, making it more profitable to lend, acting as a stimulus to business growth.

Besides, the stock market has priced in the Fed’s tapering, which it has promised to start in 2022. The real risk to the stock market is a prolonged increase in long-term rates due to continued inflationary pressures. The Fed keeps waffling back and forth on whether rising inflation is transitory or here to stay. However, if the Fed were confident that recent historic spikes in inflation are the beginning of a longer-term trend, it would act now, as would the stock market, which, thus far, doesn’t seem bothered by it. It still appears that the sharp increases in the inflation rate are temporary adjustments to pandemic-induced supply and demand imbalances that should subside over the next few months.

Don’t Fear Volatility, Embrace It

It’s important to remember that the media doesn’t feel relevant unless pitching hyperbolic headlines that scare investors. That’s not to say you should ignore negative events as they occur. It’s good to be informed about things that might impact you in the short term. But it’s essential to keep it all in perspective, especially as it relates to the impact on your investments. The next 20% decline in the stock market, whenever it occurs, will show up as a minor blip on your investment performance over the next ten years and hardly noticeable over the next 20 to 30 years.

In the meantime, we can expect more risk and volatility in the months and years ahead. But, as we have often said, risk and volatility are good things because it’s where returns come from over the long term. Lower prices help increase future returns and decrease risk. Investors should welcome the next big stock market correction as a normal part of the market cycle. It may sound counterintuitive, but that is how you make money in the market – by taking advantage of periods of dislocation when stock prices don’t reflect their underlying business value.