Stock markets around the world rallied strongly in March, continuing the rebound that began on February 12. In the US and emerging markets, the rebound has wiped out the deep losses from the first six weeks of the year to deliver positive returns for the quarter, as the Display shows.
The magnitude of recent market swings has been dramatic, and consistent with our view that we are in a “risk-on/risk-off” environment rather than an environment with a strong positive or negative trend. The US, international developed, and emerging-market stock market indexes all lost more than 10% in the first six weeks of the year, and then bounced back dramatically, as the Display shows.
In statistical terms, such large market drops in so short a time are more than a two-standard-deviation event. That is, they had less than a 5% chance of occurring. The rebounds that followed were even less likely.
What caused these massive moves? The downdraft reflected fears that the drop in oil prices below $30 per barrel reflected falling demand from a slowing global economy, including slower-than-expected growth in China. The rebound reflected recognition that market forces will reduce excess oil supply over time, plus expectations of ongoing central bank support. Both the European Central Bank and the Federal Reserve, in fact, delivered support in mid-March, and Federal Reserve Chair Janet Yellen reconfirmed it in comments near month-end.
Sentiment swings wildly
In our view, both the drop and the rebound were greater than fundamentals warranted. As we have written before, in a risk-on/risk-off market, sentiment swings wildly in response to hints of a change in the macroeconomic outlook.
Hints of negative change prompt sell orders for risk assets such as stocks, driving the stock markets down and volatility up. Hints of positive change prompt buy orders that drive the markets up and volatility down. That is, volatility itself becomes volatile. The Volatility Index, or VIX, spiked to above-average levels in the first six weeks of this year—and has fallen to below-average levels since then. It could easily reverse again.
While some measures of short-term equity risk have fallen, our proprietary volatility forecast remains closer to average, and we continue to believe that bouts of elevated risk could recur. As a result, our Dynamic Asset Allocation team is deliberately responding more slowly than usual to changes in volatility and has kept private client exposure to stocks modestly below target to varying degrees since stock-market volatility spiked last August, while overweighting high-quality bonds.
At the end of March, with forecast volatility close to average, the team pared its stock underweight for moderate-risk private clients. We reduced the stock underweight by buying call options, which allow clients to participate in potential equity market upside with limited downside risk. Options are particularly inexpensive at times, like the present, when volatility is low.
Within equities, we are modestly overweighting the US and emerging markets and underweighting non-US developed markets. The emerging-market overweight is new. A persistent valuation discount, improving exports, and improving market sentiment led us to favor emerging markets after underweighting them for more than two years.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.