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What's Keeping Investors Up at Night?

Byline: Gil Weinreich

The return of volatility to a market that has placidly delivered high average returns for six consecutive years may need a bit of explaining.

Then again, maybe not.

Maybe the very fact that the market has placidly delivered high average returns for six consecutive years is making investors nervous, and making 2015 a year in which intraday swings of 1% to 2% have been common so far -- (though "death of volatility" research reports were all the rage in 2014).

A commentary by USAA equity fund manager John Jares attempts to put the return to volatility in context.

Jares' perspective is well timed, coming as it does during the week in which the bull market has registered six consecutive years since the March 9, 2009, market bottom amidst a frightening global financial crisis that saw asset prices continuously plunge starting from the Fall of 2007.

Noting that the subsequent 72 months brought average annual returns exceeding 23%, Jares writes:

"The question before markets opened Tuesday was "Can the bull keep running for another year?" The showing on day one of year seven -- a 1.7% drop in the S&P that pushed the index down into negative territory for 2015 -- was not an auspicious start."

The USAA manager argues that key questions concerning monetary policy and economic trends are heightening investor uncertainty, thus fueling the current volatility.

The monetary question involves whether and when the Federal Reserve will raise short-term interest rates. The six-year-old bull market occurred in its entirety amidst a backdrop of zero or near-zero rates, making the prospect of Fed tightening ... frightening.

That said, Jares points out that conventional market factors have contributed to higher stock prices, including Q4 earnings that have exceeded analyst estimates and an improving economy that has registered rising wages, job growth and high consumer confidence.

This good economic news, ironically, may exert pressure on the Fed to normalize policy rates away from emergency-condition zero rates of the past several years.

"We have never experienced six-plus years of near-zero policy rates, so no one knows how the yield curve will respond once rate hikes commence," Jares writes. "If short-term rates rise more than longer-term rates, it is a signal that the recent economic growth may not be sustainable and that a recession may be looming."

Another sign of economic robustness that similarly serves to magnify investor uncertainty is the strength of the dollar, which has been persistently rising for close to a year now.

The launch this week of the European Central Bank's quantitative easing (QE) program propelled the dollar to new heights against the euro, while the Bank of Japan's ongoing QE program has led to the dollar's eight-year high against the yen.

While consumers benefit from a strong dollar, Jares points out that larger U.S. companies that export abroad (whose products will now be priced more expensively in local currencies) are already projecting declining profits for this year.

In this context, USAA is "neutral" U.S. large-caps, but it is also underweight small-caps and fixed income. The fund company prefers investment grade and high-yield bonds, and is overweight ex-U.S. developed market stocks, emerging-market stocks and real-return assets that can hold up in an inflationary environment.

After explaining what's keeping investors up at night, the USAA manager acknowledges that none of those reasons assure the market will crater either.

"The current bull market has lasted far longer than the average, so investors are unusually sensitive to possible signs of a reversal," Jares concludes. "At the same time, there is also no clear reason why the upward trend for stocks has to come to an end this year. When you put it all together, the stock market has more questions than answers, and that is what makes it nervous."

--- Check out The Great Mutual Fund Comeback on ThinkAdvisor.
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Publication:ThinkAdvisor
Date:Mar 13, 2015
Words:639
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