By Guest commentary Thursday, October 26th, 2023

By Arthur Swalley

This year’s third quarter saw a retreat across markets after the significant run-up of the year’s first half.

The most prominent technology companies of the S&P 500, known as the “Magnificent Seven,” made up the great majority of the index’s 13.2% gain for 2023 so far. 

Comparatively, the Dow Jones Industrial Average and the Russell 2000 index of smaller capitalization stocks were up only around 1%. 

2023’s results have entirely flipped from 2022, when the “Magnificent Seven “and companies with no earnings were down 30% or more, with the Dow and Russell 2000 down only single digits. 

The natural question arises: Why is there so much volatility?

Over the past 40 years, the S&P 500 has experienced two significant declines of more than 50%: the “tech wreck” of 2000-02 and the Great Recession of 2008-09. 

The markets have also experienced the Crash of 1987 and the Covid crash of 2020, each falling over 25% within two weeks. 

While stock returns the past two years have been mixed, broad stock market volatility has not been as high as it has been in the past.

Several factors have led to lower volatility. From a behavioral standpoint, investor experience that stocks have historically rebounded and thrived after suffering declines has made markets more resilient.

 Implied and direct government support of financial institutions has increased dramatically over the past four decades, resulting in less fear of contagion. 

Increased regulation and oversight of corporate financial and governance disclosures have led to more investor confidence in the quality of earnings reports and projections. 

The world has enjoyed relative peace and stability, leading to a flowering of global trade and expansion of market opportunities.

Admittedly, this (incomplete) list of factors could change with little notice; one evergreen constant plaguing equity markets is pundits’ ability to point out all the aspects that could go wrong and send volatility soaring. 

The fears of market volatility often keep the average investor from putting money to work, especially at the best time to invest — after equity markets have declined or had mixed results.

 As a result, many investors seek the perceived safety of US Treasury bonds and similar bonds, like municipals and CDs.

Interestingly, US Treasury bonds have experienced the most volatility in the markets (excluding companies with no profits) since the outbreak of COVID-19. 

The most extreme example is the 30-year Treasury bond issued in April 2020 (coming due May 1, 2050!), which has lost over 50% of its value, equivalent to the worst post-Great Depression stock bear markets. 

Although a bond that returns 5% annually can be bought today, it is still not very attractive compared to the average long-term return of 10% for the S&P 500.

Less extreme data points still look bad for “safe “bonds. 

Last year saw a 19% decline for Bloomberg Barclay’s long-term investment grade bond index while this year has seen another 2.5% downdraft. 

This spring’s bank mini crisis was primarily caused by the decline of the government bond market, unexpectedly impacting the banks’ balance sheets.

On the surface, two assets that have done well are short-term money markets and bonds with less than one year of maturity. 

Five percent sounds like a pretty good return — until it is compared to inflation, which has been running higher than 5% over the past two years.

Amidst the current bond market turbulence, it’s worth noting that stock market volatility can actually be a positive attribute to achieve returns that outpace inflation. 

Although market volatility in the short-term may make some investors hesitant, taking a long-term approach to owning stocks within a disciplined financial plan has historically been a successful strategy, and we are confident that this approach will remain relevant in the future.

Arthur Swalley is a partner and director of investments at Arlington Financial Advisors in Santa Barbara.