The S&P 500 rallied over 5% in January, with small and mid-caps doing even better. Market strength continued into mid-February, with the market gaining another 2% between January 31st and the recent high on February 19th.
However, as I expected, gains have now become harder to come by. Over the last week stocks have pulled back and volatility has once again spiked. This pickup in volatility can be seen in the numbers. Since bottoming on February 1st, the one-month trailing realized volatility on the S&P 500 has nearly doubled and the VIX index – which measures implied volatility – has spiked over 50% from last week’s multi-year low. What happened?
- The spigot got turned off. Equity flows were flattered by two forces in January: seasonality and the reversal of some unusual tax-related selling in December. This produced a spectacular month for stocks, which many investors attributed to the beginning of a “Great Rotation” out of bonds and into equities. The reality looks more prosaic: money came off the sidelines in January. While this trend can obviously continue, the pace of new flows has slowed dramatically in recent weeks.
- The fiscal drag is exerting an impact. Economic releases in January looked strong, but remember — we were mostly looking at December’s numbers. More recent economic data, which now covers the start of 2013, has been decidedly mixed. While the housing market continues to improve, we’ve recently seen a string of mediocre manufacturing reports, particularly the Philadelphia Fed Survey. In addition, consumption is slowing in the face of the recent tax hikes. More fiscal drag, in the form of the sequester, will not help.
- Politics, on both sides of the Atlantic, remain dysfunctional. For anyone who had hoped that the politically driven volatility of the last several years was over, the last few weeks have been an unpleasant reminder of the state of US and European politics. Divisions in Washington are arguably worse than before, as Congress and the White House prove incapable of averting the sequester, which was itself intended as a crude device which politicians would never allow to actually happen. Before year’s end, investors will be treated to at least another three episodes of the fiscal soap opera: the expiration of the continuing budget resolution on March 27th, another round with the debt ceiling this summer, and the fiscal 2014 budget battle in the fall. And not to be outdone, Europe has recently reminded investors that politics there still reside somewhere between tragedy and comedy. The Italian elections resulted in the political equivalent of a hung jury. To the extent this delays further economic reforms in Italy, this is a negative for both Italy and Europe.
So far, none of the above issues represent an existential threat to the market, but they do shift the investment dynamic. The last few days have reminded investors that while the world looks better than it did a year ago, many of the old risks – sluggish growth, skepticism towards stocks, and political dysfunction — are still with us.
I continue to advocate that investors be selective about where they commit new capital and consider reducing any overweight positions they may have to US stocks as a whole. Instead, I’d advocate investors consider overweighting segments of the international market most levered to global growth and segments of the US market generally less sensitive to domestic growth. US mega caps, accessible through the iShares S&P 100 Index Fund (OEF) and the iShares S&P Global 100 Index Fund (IOO), are examples of the latter.
The author is long IOO