Volatility is back, but there is no recession on the horizon—yet

Back in August, we wrote that the heightened volatility in U.S. equity markets, while unsettling, was more rule than exception, and that a dip in stock prices was actually overdue.

Since then, the stock market has continued to be violently flat, with January's losses erasing the gains made in the fourth quarter of last year. As 2016 unfolds, many investors are wondering whether there is more behind this recent market decline than a loss of confidence—is this the start of a prolonged bear market? We put the question to our network of asset managers and research firms, and we offer some context for the recent downturn.

Market pullbacks are common—and necessary

The S&P 500 Index's precipitous drop in January marks the second stock market correction—a decline of 10% or more—in the past six months, and both developed quickly. This summer's correction took place in little more than a week at the end of August 2015, but prior to that decline, there hadn't been a correction in more than four years, and investors were beginning to wonder how much longer that trend could last. As we pointed out then, there is nothing special about the 10% threshold and the stock markets have in fact been fairly volatile in recent years: Over the past five years, there have been 10 stock market declines of more than 5%, including the current slide.1 Many sources in our network are reluctant to call today's levels the bottom, however, and it's entirely possible the stock market could fall further before it recovers.

But there is good news: U.S. equity valuations had, by most measures, appeared stretched if not outright high for much of 2015. While the consensus from our network is that investors should expect more muted returns and higher volatility for stocks going forward, today's valuations suggest an appealing entry point for long-term investors. Over the past 60 years, when stocks reached valuations similar to today, they went on to return 7.3%, on average, over the subsequent decade.2

No recession on the horizon, but the outlook is far from rosy

As for the economy, we continue to believe that the United States is somewhat insulated from global economic factors, and our network has stated that we are not on the verge of going into a recession—yet. Four of ten leading economic indicators (LEI) are currently positive, and while the overall LEI level has been declining since 2014, the absolute level remains higher than it was for much of 2011 and 2012.3 There's something of a tug of war happening behind the scenes regarding the LEI data: Manufacturing and capital expenditure data has been persistently weak, and the bright spots in the data—yield spreads, credit, and the labor market—have increasingly struggled to offset that weakness. The key factors to watch are whether the dollar continues to materially strengthen in 2016 and whether oil prices continue to hover near their current $30-a-barrel levels. Neither would be good news for the economy.

Our network's view is that the first quarter will be a soft patch for the U.S. economy, but that the stock market will be affected by far more than the economic outlook. One new reality that stock market investors will need to adjust to is life without the so-called Bernanke/Yellen put. Since 2008, the U.S. Federal Reserve (Fed) has served as investors' cavalry, riding in to flood the market with liquidity at the first sign of trouble. While the Fed is no longer actively easing and began raising short-term rates in December for the first time in nine years, monetary policy remains extraordinarily accommodative by historical measures, although perhaps not as accommodative as some investors would like.

Consider allocating to alternatives to dampen volatility

Our network suggests that volatility is likely to persist, and the fact remains that economies outside the United States are on less stable footing than our own, while the correlation of U.S. to global equities has been extremely high for years. Although there are reasons to believe the U.S. stock market appears to be approaching an attractive valuation, global macroeconomic risks will likely continue to whipsaw U.S. equity prices.

At John Hancock Investments, we continue to favor the use of alternatives as a potential way to reduce risk in this type of environment. A well-constructed asset allocation strategy has historically helped reduce portfolio volatility and mitigate the risk of significant losses. In addition, absolute return strategies can offer a more targeted approach by pursuing positive returns independent of markets and traditional benchmarks. In today's uncertain market, we believe there is much to recommend this type of defensive approach.

 

1 Bloomberg, as of 1/21/16.

2 Standard & Poor's, Bloomberg, as of 12/31/15.

3 The Conference Board, as of 1/22/16.

The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results.