Stock market volatility is finally returning to pre-pandemic lows, which many investors are taking as a sign of smooth sailing ahead. There are certainly reasons to feel optimistic as economic indicators and corporate earnings signal recovery. However, the full picture is a bit more complicated, and your investment portfolio should still be built to manage potential volatility spikes.
The VIX dropped below 16
The CBOE Volatility Index, or the VIX, dipped below 16 last week, which is around the lowest it has been since the pandemic started. A low VIX means that prices are not fluctuating wildly up and down, and that relative steadiness suggests that the market is being less influenced by investors' fears. Given that the S&P 500 Index isn't moving too violently right now, it seems like investors are comfortable with the status quo -- for the time being.
Low volatility can certainly be a positive signal, especially in the short term. However, investors should definitely take time to think about why volatility might be low -- and when those underlying conditions might change. In the worst-case scenario, this dip in the VIX could be evidence of a level of investor complacency that's feeding into a stock market bubble. You definitely don't want to buy too cavalierly into that cycle and then get caught holding the bag when the bubble bursts.
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Hidden volatility
If you look below the surface, the low volatility in the market today is somewhat misleading. Without digging too far into the nitty-gritty, the VIX's methodology measures the amount of volatility for the S&P 500 Index as a whole. So even when the VIX is low, individual stocks or entire industries can still be undergoing significant turmoil.
While the S&P 500 has been hitting all-time highs recently, there is a meaningful rotation occurring between value stocks and growth stocks. The reopening of large swathes of the U.S. economy is encouraging investors to shift assets back into industries that suffered during the pandemic's prior stages such as transportation, hospitality, financials, energy, and retail. Meanwhile, many of the technology and healthcare stocks that achieved historically high valuations last year are falling out of favor. Concerns that the Fed will start to raise benchmark interest rates off of their historic lows to prevent inflation are making that rotation even more extreme.
If you have a lot of growth stocks and tech stocks in your investment portfolio, you may be experiencing a lot more volatility than the current mild VIX level might suggest. You might also be in for even more turmoil in the months to come.
Investors are in wait-and-see mode
While there is a rotation in and out of various types of stocks going on, all sectors are still inching higher. Even the "losers" are still rising, but there's an element of "calm before the storm" right now. First-quarter earnings season is behind us, so it'll be a few months before another big batch of corporate financial reports is released. Investor focus has turned toward economic indicators and Fed commentaries, which could be either underwhelming or transformational as they are published.
Without as much company-specific news to move the needle, we're in a bit of a holding pattern until there's more certainty about when the Fed will adjust its interest rate and economic stimulus policies. Many people think that the Fed will start winding down its stimulus activities this year. However, others still expect the central bank will stick to its previously stated plan to hold the fed funds rate at its current level for a few years, even if that results in some inflation. I tend to think that an earlier shift in policy is more likely, given the economic data and the likelihood that the timeline the Fed proposed last year was designed to instill confidence and prevent panic.
As soon as it becomes clear that the Fed will raise interest rates, volatility will probably spike. Capital will start flooding toward cash and bonds, and away from stocks -- especially from high valuation growth stocks. Nobody can know for sure when that will happen, and we won't be able to confirm it until the Fed states clearly that they are tapering. However, any news along the way that shows higher-than-expected employment or inflation will get people anxious about monetary tightening. That's why we're in this odd wait-and-see scenario.
Don't panic
Volatility isn't necessarily a bad thing -- it's a natural part of how capital markets function. In fact, if volatility is induced by monetary tightening, that means that the economy is getting healthier and things are going back to normal.
Ultimately, you just have to make sure that your stock portfolio and overall strategy are built to handle those share price swings. It's helpful to diversify across sectors so that you have a mixture of value and growth stocks. If you don't want to diversify, then make sure that your overall financial plan is set up to endure temporary downward moves. Don't freak out if stocks dip in the short term, and do what you can to ensure you won't be compelled by circumstance to sell from a down position to meet your cash needs.
Make sure your short-term cash needs are covered regardless of what happens in the stock market. Come up with a long-term investment growth strategy, and stick to it.
