The stock market correction that happened last week was due to a surge in volatility that caused stock prices to plunge as investors started to realize that the calm of the past two years had to give at some point.
That's according to Liz Ann Sonders, chief investment strategist at Charles Schwab, who said that volatility caused the sell-off, not the other way around. After all, fundamentals are strong, with growth in corporate earnings and global economies also seeing strength. She pointed to the Bank of America Merrill Lynch Global Fund Managers Survey of January as further evidence that volatility was to blame for the sell-off. The survey showed in January that the most crowded trade was short volatility, even replacing the long bitcoin trade as the most overcrowded one for the month.
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"The culprits of the spike in volatility have been exchange-traded notes (ETNs) – notably the VelocityShares Daily Inverse VIX Short Term ETN (XIV), which collapsed to effectively zero during last week's turmoil," wrote the executive at The Charles Schwab Corporation (SCHW) in a blog post. "This was courtesy of the parabolic surge in the CBOE Volatility Index (VIX), with the XIV (among other inverse products) moving in the opposite direction."
While the markets have been behaving less frantic in the past few days, Sonders thinks the volatility is here to stay. And that's even if the technical correction due to investors covering short positions betting against volatility increasing is over. She said that the low inflation and low volatility era is also behind the markets now. "The bull market, although likely still intact, will be met with sharper bouts of volatility and greater frequency of pullbacks/corrections," she wrote.
With volatility here to stay, it may require some investors to make changes to their approach to investing, and Schwab has tips to do that. One technique, according to Charles Schwab, is to get defensive in investment choices. In another recent blog post, the San Francisco-based discount brokerage said that investors may want to look for defensive assets including cash, cash equivalents, Treasury securities and U.S. government bonds in times of volatility. The firm said that investing in those defensive classes can help stabilize a portfolio as stocks decline. Having investments in cash and short-term bonds is also smart for investors who need to access their money in the next few years because it will help them avoid selling investments in a down market. Read about whether you can make money in stocks.
Investors who have to trade during times of increased volatility can also take defensive steps by considering the current market conditions when entering orders. The discount brokerage pointed to stop orders and stop-limit orders that will protect unrealized gains or limit potential losses as well as boost an investor's confidence as he or she trades when markets are acting with volatility.