Volatility is back with a vengeance, and for investors who have gotten used to the relative calm in the markets over the past two years, the timing and "violence" of the move is sending them to the hills. Still, despite that fear and dread, the recent sell-off in the stock market may not be a harbinger of more pain to come, thanks in large part to strong corporate earnings and growth in economies around the world. At least that's what Charles Schwab thinks, even as volatility is back and likely here to stay.
"Although we don't yet know the extent of the carnage within and associated with the short-vol space, we do believe the recent pullback is healthy for the continuation of the bull market," wrote The Charles Schwab Corporation (SCHW) in a recent blog post. "According to the Ned Davis Research (NDR) Crowd Sentiment Poll, investor optimism has come off the record highs seen a couple of weeks ago. We believe some of the recent action is part of a process of resetting investor expectations to more reasonable levels."
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With stocks nearing the correction phase late last week, the increase in volatility resulted in a "massive" unwinding of short volatility positions and the forced selling of other stocks or assets to cover short portions. Schwab noted that the short volatility trade has replaced the long bitcoin trade at the end of January. And while traditional fundamentals remain good – corporate earnings are strong, consumer confidence is increasing and the job market remains robust – expectations are at such a high level that it was only a matter of time before volatility seeped into the stock and bond markets.
Furthermore, investors' expectations for corporate earnings needed to come down a bit. "While strong earnings growth – and the recent pullback – helped ease the high valuation problem, the enthusiasm around the tax-related boost to earnings may have gotten ahead of itself. This could be seen in individual stocks selling off with even minor disappointment during their earnings reports," said Schwab.
The pullback in stocks, which is what Schwab is calling the recent sell-off, is also affecting international markets, with many overseas issuers back to where their shares were trading at the end of last year. Still, Schwab does not think this will spill over into currencies, commodities and credit at the current time, nor that the bull run in stocks is over. "We don't believe the bull market's continuation is in great danger at this point, but we are watching the aforementioned market structure dislocations as well as the more fundamentally-oriented inflation picture," the brokerage firm said. "It isn't unusual to see pullbacks. The peak-to-trough drawdown in global stocks so far this year, at about 8%, is only about half of the average annual pullback of the past 37 years. That could mean there is more to come, either for the current pullback or additional pullbacks over the course of the year."