Outlook: Volatility To Continue, Stocks To Lead

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Brian Sterz, CFA

Summary

Volatility has returned to the markets and is there to stay for 2018.

Strong economic fundamentals at odds with the Federal Reserve raising interest rates and uncertainty of global trade negotiations.

Intermittent bouts of volatility are creating opportunities for patient investors that see through the noise.

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Volatility has returned to the markets this year, largely thanks to an epic tug-of-war between strong fundamental economic growth and rising interest rates. While the current uncertainty is likely to continue for the rest of 2018, the long-term drivers that fueled a rise in stocks last year are still in place. Thus, stocks still appear to be positioned to move higher on the back of a strong economy and should lead most other asset classes during the remainder of the year

Economic Fundamentals Are Solid

Numerous data points show how strong the economy's foundation is. Global GDP growth is expected to hit 3.1% this year which, according to the World Bank, is the highest growth rate since 2010. Additionally, emerging markets are on track for their highest GDP growth rate since 2013. For the cherry on top, the unemployment rate in the U.S. is at its lowest level since the turn of the century.

Corporate tax cuts passed in December have spurred both share buybacks and higher dividend payouts. Profitability, by and large, is higher as well. Earnings are on pace for their best growth rate since the third quarter of 2010, while the tech sector specifically posted 34% year-over-year earnings growth during the first quarter. These numbers add up to a bullish environment for stocks.

So, Why The Volatility?

Overall, the long-term drivers of economic growth, which propelled substantial gains during 2017, are still in place. However, higher interest rates and increased commodity prices are on the other side of this tug-of-war match. Investors are looking for growth that is strong enough to propel future gains, but not overpowering enough to cause the Federal Reserve to raise interest rates faster than expected. Higher borrowing costs have negative side effects for consumers and corporations alike.

The market's strong fundamentals are facing other headwinds too. Protectionist trade policies and tariffs, which tend to produce losers not winners, threaten to dampen domestic and global economic growth. For the cherry on top, political headlines are negative overall.

In light of these conflicting factors, the volatility we've seen this year isn't surprising - though it is a contrast to the smooth run we've had in recent ones. Right now, stocks and bonds aren't trading too far outside their values at the end of 2017. Bonds (Bloomberg Barclays Aggregate Bond Index) have lost just over 3% of their value during that time, while stocks (S&P 500 Index) have gained around the same amount. But it's been a rocky ride to the current levels.

Stocks Are Still Your Best Bet - Here's Why

The factors causing investors to be skeptical of stocks this year are surface-level considerations - ones that make for panicked headlines and reactionary investing. They also serve to obscure the economy's continued strong foundation which, once again, isn't hard to see if you're looking in the right place: GDP growth, unemployment, and earnings all look great. These data points are just decent; much of the growth represents the best we've seen in years. There are no waving red flags suggesting the economy's strong foundation will crumble long term, either.

Expect the markets to remain volatile as the tug-of-war between growth and interest rates continues - especially because stocks and bonds alike are reacting violently to headlines, which change rapidly. Investors shouldn't be focused on those headlines, though. There's opportunity to be seized in the volatility, but only if you're able to tune out the noise and keep your eye trained on the long-term drivers that really matter.

How To Position Your Portfolio

Stocks should continue to outperform bonds for the remainder of the year - though investors shouldn't expect returns to be as substantial as the year prior. As already mentioned, emerging markets and technology have the most momentum so far in 2018. For emerging markets especially, a strengthening dollar has caused a pull-back this year - but like the downswings in the broader market, that should be temporary.

Alternatively, bonds are on pace for their worst year in this century, but that should mean some attractive yields for the first time in a decade during the next year or so. Also, just because stocks are set to outperform doesn't mean fixed-income should be completely ignored. Savvy investors will steer away from traditional bonds to asset classes less correlated with U.S. interest rates such as MLPs and emerging market debt.

While headlines are relatively negative right now, underlying economic data continues to support the global growth story and at least modest gains for stocks going forward. This volatility presents an opportunity for investors who don't get caught up in the noise.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.