Our Perspective on Volatility and Fast-Rising Price Fears

Ouch. That word, we imagine, sums up many investors’ feelings about the S&P 500’s first sharp burst of negativity in nearly two months. After closing last Friday at all-time highs, the index dropped -1.0% on Monday, -0.9% on Tuesday and -2.1% today—a total drop of -4.0%.^[i] Volatility like this can strike any time, for any or no reason, but sentiment usually plays a dominant role. This time, that sentiment is rising fear over inflation, especially in the wake of today’s report showing US CPI inflation speeding to 4.2% y/y.^[ii] This, plus jumping commodity prices and reports of shortages, has sparked doom-laden 1970s comparisons. Whenever this happens, we think there are two big things all long-term investors should do: Breathe deep and resist the urge to react. Rough patches are normal in any bull market, and enduring them is key to reaping bull markets’ big returns.

This pullback isn’t yet a correction, which is a sentiment-fueled drop of -10% to -20% or so from a prior high. Maybe it spirals into one, maybe not—there is no way to know. Corrections don’t operate on schedules, and volatility doesn’t predict volatility. If the market’s day-to-day whims were foreseeable, the investment hall of fame would be full of people who timed corrections repeatedly, selling precisely at their tops and buying back at their depths. But that wing of the hall is empty. Predicting short-term volatility is impossible, and anyone who preaches otherwise is selling you a bill of goods.

In our experience, those who try to circumnavigate corrections most often wind up selling low and buying high. That is a recipe for missing returns, not reaching a set of long-term investment goals. So if your gut is telling you it is time to sell to miss further declines, remind it that you could also miss a big rebound that renders the last three days invisible on a chart of any material timeframe. Remembering your long-term goals at times like this is critical.

Also critical? Taking headline fears in stride. Yes, inflation jumped. Yes, April’s year-over-year rate is the highest since the global financial crisis in 2008. But reacting to this after markets have already reacted to the news is wrong. Goodness knows Fed officials aren’t always right, but we do think they are correct that this inflation jump is likely temporary. As we have shown in past commentary, we were virtually assured to see a month-over-month pop as more and more states reopened. Jumpy prices are also normal early in economic recoveries. The last time CPI rose 0.8% m/m, as it did in April? June 2009—when the US was exiting recession.^[iii] That usually happens because demand improves while producers are still running at low capacity after recessionary cutbacks. Today’s situation is a pandemic version of that. Beyond used cars, whose prices soared, shelter (particularly lodging away from home), airfares and recreation were key contributors to the rise. That looks like a reopening bounce, as areas most impacted by the pandemic drove up prices. That probably won’t last as the initial pent-up demand boom fades.

As for the year-over-year figure getting so much ink, that is mostly garbage right now due to the denominator in that year-over-year calculation. April 2020 is when prices hit their nadir during lockdowns, which skews the math considerably. The question today is, how long will this persist? We doubt it will be anywhere near as long as fearful headlines claim today, considering the flawed logic underpinning their arguments. But that is an article for another day. For now, we will simply point out that with inflation dread swirling for as long as it has, surprise power is largely spent. That makes runaway inflation unlikely to end this bull market in the near future. 

In the meantime, use this opportunity to set expectations, because even if this volatility doesn’t escalate into a correction, we will get one eventually. Actually, this bull market has already gone longer without a correction than its predecessors. The March 2009 – February 2020 bull market got its first correction in April 2010. Before that, the October 2002 – October 2009 bull market notched its first correction in November 2002. The 92.7% rise between March’s low and last Friday’s most recent high without a major interruption could have skewed anyone’s perspective, making speedbumps look unusual.^[iv] They aren’t.

Volatility is part and parcel of bull markets, and in our view, pullbacks are healthy. They help keep sentiment from getting overstretched, taming euphoria as it starts to simmer. That can lengthen bull markets’ lifespan, helping the party last longer than it otherwise might. All bull markets end eventually, and this one will, too. But last year’s lockdown shock aside, bull markets usually end with a whimper, not a bang. So give it time, and keep your eye on the prize: stocks’ high long-term returns, which include all negativity along the way.