Swings don't signal bull's demise

The stock market is on a far scarier roller coaster today than a year ago, but it hasn't flown off the tracks.

The S&P500 index fell 6 per cent last week, its worst start to a year ever. Volatility has surged to the highest level since September. That these developments are accompanied by terrifying headlines — plunging stock prices in China, North Korea's test of an alleged hydrogen bomb, heightened violence in the Middle East – only adds to the feeling that something is profoundly wrong.

Yet, the market's sudden swings might not mean that stocks will be heading lower. Instead, they could be signaling a return to normalcy.

What do I mean? While the focus last week was on developments overseas, the problem looks to be closer to home — specifically, at the Federal Reserve. The Fed has not only ended its bond-buying program — its asset grab was a key cause of ultra-low market volatility in 2013 and 2014 — but it raised interest rates, too. With the shock absorber of asset purchases gone, markets now feel as shaky as the Coney Island Cyclone.

Volatility frequently has increased whenever the Fed hiked rates, notes UBS strategist Julian Emanuel. “Even though the Fed eventually hiking was the most telegraphed thing since the sun rising every morning, you were going to have a period of volatility around that rate hike,” he says.

Before panic ensues, let's understand something: the market isn't hugely volatile, at least not yet. The CBOE's Volatility Index, or VIX, closed Friday at 27, nearly 60 per cent higher than a year ago. But that isn't such a rarified level.

From 1990 through 2014, the market's so-called fear gauge spent nearly a third of its time between 20 and 30, says Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors. In 2013, however, the VIX spent just 1 per cent of its time in that range, and in 2014 just 5 per cent. As a result, when the big moves come, it “feels like the world is ending,” Chintawongvanich says. “In retrospect, the volatility is normal.”

Nor does it have to mean that the market will finish in the red this year. Nicholas Colas, chief market strategist at Convergex, notes that the VIX has averaged about 20 since its creation in 1990, and through all periods of calm and storms, the market has returned 7.2 per cent a year — returns that would make most of us happy. My own numbers suggest something similar. Since 1990, stocks have averaged a 5.8 per cent return during 12 month periods when the VIX averaged more than 20. That's a good deal less than the 16 per cent return during periods where the VIX was below 20, but it still is reasonable.

For investors worried that today's higher volatility signals the end of the world, these findings should prove comforting. “It is absolutely possible the market is up at the end of the year,” Colas says.

Whether or not stocks end the year higher will likely depend on corporate earnings. That's because there is a link between volatility and valuation, says Evercore ISI strategist Dennis DeBusschere. When markets are calm, higher valuations make sense, because the risk of a large plunge in the value of stocks is mathematically unlikely. Higher valuations become more of a problem, however, when volatility is greater, because the odds of a big move have increased.

To account for the greater risk, valuations have a tendency to be lower during periods of elevated volatility and higher during periods of relative calm, DeBusschere says. The S&P500 currently trades at 15.3 times forward earnings, but with the VIX at current levels, its valuation should be closer to 15. That would imply an index price level of around 1900, if 2016 estimates are accurate — 1.1 per cent below Friday's S&P close of 1922.03.

The simplest way to avoid a drop, then, is for earnings to come in better than analysts have predicted, raising the E in the P/E equation. At first glance, that doesn't seem likely. Oil prices, which dragged down the profits of energy companies in 2015, continue to fall. What's more, the strong dollar acts as a drag on the profits of companies doing business overseas. And foreign economic growth remains weak, creating more problems for such companies.

As a result, investors are concerned that corporate profits will disappoint when earnings season begins this Monday with Alcoa 's (AA) profit report. That might not be the case, says Thomas Lee, managing partner at research firm Fundstrat. He notes that the strong dollar caused S&P500 earnings in 2015 to be $93 billion less than they would have been had the dollar been flat. Should the dollar remain in place from here, earnings could surprise to the upside. A more stable oil price would also provide a boost.

Yes, there will be wilder swings, but the ride isn't over.

 *This report is republished with permission from Barron's.