The first quarter of 2018 was marked by the return of volatility to the stock market. This development wasn’t unexpected, as it came on the heels of a nine-year benign market for stocks. Continued corporate stock repurchase activity was also largely expected. Since the financial crisis, companies have repurchased stock to the tune of $4 trillion, primarily using leverage. As a result, today’s price-earnings multiples1 look better than they might have otherwise. Generally speaking, earnings growth has not kept pace with earnings per share. In light of these developments, Vaughan Nelson expects a certain amount of stock price dispersion in the market moving forward. We also expect that elevated volatility will remain – and that this could be a healthy development for the market.

Central banks tighten purse strings
Since the end of the credit crisis, generous central bank-sponsored liquidity has been a reliable constant. However, in today’s environment, central banks in Europe and Asia are beginning to consider a reduction in overall market liquidity. The European Central Bank is beginning to taper its quantitative easing (QE)2 program, and the Bank of Japan (BOJ) is enacting “yield curve control” – using QE to help keep its 10-year government bond yield at zero.

Liquidity changes direction
When compared to the Bank of China, the ECB, and the BOJ, the US Fed has the smallest balance sheet. Nonetheless, it is taking steps to change the direction of a long-running ramp up in overall market liquidity. The Fed has already begun to increase the federal funds rate, the interest rate US banks charge to lend each other funds overnight. In addition, the US government has implemented meaningful legislation in the form of the Tax Cut and Jobs Act. The new law’s effort to repatriate overseas capital from US corporations represents approximately $2.6 trillion that will flow back to the US. All of this signals a big shift in the direction of liquidity.

Waiting passively
Further compounding liquidity momentum is asset growth in lower-priced passive index products such as index funds. By design, index fund investing strategies are not price-motivated. The removal of liquidity by central banks could have ramifications for stock prices – it could result in a surprise on the downside. Because passive investments3 derive value from liquidity rather than price discovery, this could negatively affect index fund performance.

Active investment4 strategies can shine
In light of these factors, we believe investors should expect further market volatility in 2018. Active managers may stand to benefit from the return of volatility and stock price dispersion in the market because they can react directly to pricing pressures related to fundamentals and valuation on stock prices. With keen insight into prevailing macro and policy shifts and business fundamentals, skilled stock pickers could have an opportunity to benefit as liquidity seeps out of the market. Concentrated flexible portfolios that buy securities based on fundamentals, calculated merit and future expectations could be well positioned for these near-term shifts in the investment landscape.
Investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

Unlike passively managed investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of the investment to achieve its objectives will depend on the effectiveness of the portfolio manager. There is no assurance that the investment process will consistently lead to successful investing.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.

1 The term price-earnings (P/E) multiple, or price-earnings (P/E) ratio, refers to the current price of a company share divided by the earnings per share of the company.

2 Quantitative easing (QE) refers to the introduction of new money into the money supply by a central bank.

3 Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio.

4 Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index.