Last Monday, the VIX Index - a measure of volatility often referred to as the "Fear Gauge" - hit a 13-month high of 21.44 and U.S. stocks registered their worst day since last June. By Thursday and Friday, however, U.S. stocks rallied significantly, with back to back days of 100-plus gains in the Dow Jones Industrial Average. What's going on?
Volatility, welcome back. Greater volatility can mean big swings in the market - up or down. That's what we saw last week, and as I write in my new weekly commentary, I believe investors should expect more of such volatility ahead. Here's why:
While commentators have focused on the turmoil in emerging markets as the reason for recent rocky market performance, I place much of the blame on disappointing U.S. economic reports. Last week's disappointing U.S. nonfarm payroll report brought more evidence that structural issues continue to bedevil the U.S. labor market. U.S. job growth remained stalled in January, the second month in a row in which job creation came in far below expectations. And the jobs report was not the only soft economic print last week. Last Monday, the ISM report - a key manufacturing survey - came in well below expectations, and the new orders component, which tends to lead gross domestic product growth, plunged. Looking ahead, the combination of further soft economic data, Fed tapering, ongoing policy uncertainty and turbulence in emerging markets means more volatility in coming weeks.
Given this volatility, many investors may be wondering: "Should I pare back my equity exposure?" My answer to the question is no. I continue to advocate that investors stick with stocks over bonds. While I expect a rockier ride and more muted gains in 2014, I believe stocks still offer better value than bonds. In fact, the drop in interest rates that has accompanied the recent sell-off has made bonds look even more expensive in comparison to equities.
As such, I continue to believe that equities will outperform bonds this year, and I view recent market softness as an opportunity to selectively add to equity positions and trim bond exposure. It's also worth noting that last Monday's sell-off in U.S. equities was well below the traditional 10% threshold that has typically defined a "correction" in the past. In short, it's not that volatility is so bad, but that we've all become conditioned to an unusually tame market. While market volatility looks bad as compared with the placid markets investors got used to in 2013, the VIX merely reverted back to its long-term average last Monday.