Volatility not necessarily an accurate measure of uncertainty on stock markets
FOR months now we have read that uncertainty will have a detrimental impact on the stock market and that it is “expensive”. In this context it is political uncertainty that has dominated.
Donald Trump's unusual and controversial policies have certainly caused a great deal of debate (and no small measure of disagreement). We also face the on-going advent of Brexit and what form it will take – how much will Parliament be involved and how smoothly could the transition go?
As if this isn't enough, there are three European elections looming this year, with the French one in late spring giving rise to much media speculation (the latest buzzword is ‘Frexit'). We are currently sitting with the FTSE 100 at about 7300, within touching distance of its all time high and the Dow Jones industrial average recently broke through the “magic” level of 20,000.
The amount of volatility in both these indices has been subdued of late, somewhat at odds with the assumption that political uncertainty causes stock market volatility: the Vix index, which measures volatility in the S&P 500 index is currently well below its long term average, for example.
Volatility is not necessarily an accurate measure of uncertainty, however. In 2008 when the financial crisis erupted, there was a high level of volatility as everyone struggled to sell and therefore prices tumbled.
Now there is a high degree of disagreement on the direction of travel of the stock market – if someone wants to sell the price does not have to fall far to induce someone to buy, hence the low level of volatility could in itself be an indication of uncertainty.
One reason for this is that we have in-built mechanisms in the form of exchange rates and interest rates which act as stabilisers and will fall to cushion the damage if it looks as though policies will depress growth. It should also be remembered that the global economy is looking reasonably healthy at present: more economic momentum should more than offset political uncertainty.
Stock market volatility and political uncertainty are not necessarily inextricably linked: in the late 1990s political uncertainty was low whereas the stock market saw desperately high levels of volatility.
There is of course no guarantee that levels of volatility will remain at such subdued levels indefinitely. There are always opportunities in the market: the focus recently has been on the strong recovery in mining and oil stocks, which have seen phenomenal gains over the last 12 months. It is rare that all sectors rise in tandem, however, and there are other sectors which have underperformed in relative terms over recent months.
One obvious example of a sector which is currently out of favour is the utility sector, where there are excellent yields to be found and indeed other defensive sectors are also looking unloved. The fundamentals should never be ignored in favour of short-term political worries and there are plenty of opportunities both for taking profits and for buying in the market today.
:: Cathy Dixon is a director at the Belfast office of Cunningham Coates Stockbrokers, a trading name of Smith & Williamson Investment Management (SWIM). This article does not constitute a recommendation to buy or sell investments and the value of any shares may fall as well as rise. Investments carry risk and investors may not receive back the amount invested. The views expressed are those of the author and not necessarily of SWIM.