In this February 9 post from the Mainstay blog, Jonathan Swaney writes about valuations and recent volatility.

What Happened?

The decline that began last week deepened yesterday and may do so again (futures have fluctuated in and out of negative territory before the market open).

Why Does this Matter?

As we wrote on Tuesday, the drop in pricing is largely divorced from anticipated economic performance or changes in corporate profitability. True, a report on Friday showing higher than anticipated average hourly earnings—on the heels of a soft productivity number—does point to mounting inflationary pressures which may have spooked investors. But these readings were not dramatically out of line with expectations, and taken alone, provide scant evidence of a material change in business activity or operating environment. We are highly skeptical that investor views as to where economic growth, company earnings, or inflation will finish the year has changed much over the course of the past week.

What's Vol Got to Do with It?

The initial selloff and corresponding spike in volatility appears to have triggered selling from some systematically driven strategies that have become popular in recent years including short volatility and risk parity. That exacerbated the slide, souring investor psychology and encouraging further selling from other investors discovering they have less appetite for risk than they previously appreciated. The decline now sits near the 10% level that constitutes the commonly accepted definition of a "correction" —an event that in prior periods occurred with some regularity, although we’ve become unaccustomed to moves of this magnitude in recent years.

The Big Picture.

From our perspective, this is an entirely healthy development that we welcome with open arms. The U.S. and global economy is on solid footing; corporate earnings are poised to grow rapidly in the year ahead; inflation is returning to a more normal level that is higher than it has been but by no means imperils price stability; and the premium on equity prices has been largely erased.

We freely acknowledge that this slide could extend for some distance yet as stockholders reassess their willingness to ride out the bumps, but calling a bottom is a fool's errand. We liked the prospects for equities a week ago, and find them ever more compelling the deeper this price slump becomes.

As such, if suitable, investors may want to consider adding to risk positions as prices fall for those with the intestinal fortitude to do so. For all others, it may be prudent to hunker down and wait for this squall to pass–buying high and selling low is never a good prescription.

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Allison Scott
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