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Don’t Get Complacent – Expect An Increase In Volatility This Year

Taking a page from the 2013 playbook, the S&P 500 is once again running straight up from a pullback low (see chart below). This is not atypical behavior following the first dip off of an all-time high, particularly one that was preceded by a long period without a 5% correction. The pattern is largely a function of psychology, as investors who “missed out” on the prior rally rush in to buy the first dip. There is a deep sense of urgency to “get in” before missing the next rally, which in turn leads to a vertical move higher.

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This positive feedback loop, of course, works until it doesn’t. Inevitably, it is broken as bullish sentiment reaches an extreme and there are fewer investors left with a sense of urgency to buy the dip. 2013 was an extraordinary year in that bullish sentiment was largely ignored and we saw a continuous feedback loop with only one minor correction.

We cautioned coming into this year that investors would be wise to avoid recency bias in assuming that repeat of 2013 was likely. We have already seen that this caution was warranted, with a 6% correction in stocks that began in January of this year while 2013 did not suffer its first correction until May. We expect this divergence to continue and while new highs in the major indices are likely in the coming weeks, don’t assume the pattern will be anything similar to 2013.

Regardless of where the year ends, there is likely to be a significant increase in volatility in between. There are a number of factors supporting this view.

Down January

In years in which the S&P 500 was down in January (as was the case this year), we observed higher volatility on average throughout the year.

Year 2 of the Presidential Cycle

We are currently in the 2nd year of the Presidential Cycle. Historically, the 2nd year has been the most volatile of the four years.

In the average Year 2, the S&P 500 has actually been flat on a year-to-date basis heading into November.

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Fed Policy Change

The Federal Reserve is expected to continue its tapering of QE throughout the year. In the last two years in which QE programs were ended (2010 and 2011), we saw a significant increase in volatility and larger than average corrections.

New Fed Chairman

A change in one of the most influential positions in the world has often preceded an increase in volatility in the markets.

Paul Volcker’s tenure began on August 6, 1979. Within the next year, the U.S. entered the first leg of a “double-dip” recession with a 17% decline in the S&P 500 in early 1980. A second bear market would begin later that year and a second leg of the “double-dip” recession would begin in 1981.

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Alan Greenspan’s tenure began on August 11, 1987. The 1987 crash occurred two months later, with a total decline in the S&P 500 of over 35%.

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Ben Bernanke’s tenure began on February 1, 2006. The U.S. housing market would peak only a few months later, setting the stage for the worst recession and Bear Market since the Great Depression. The S&P 500 would reach its peak the following October, suffering a decline of 57% over the subsequent 17 months.

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Janet Yellen’s tenure began on February 1st of this year. She is assuming the chairmanship at the same time the Fed is winding down its latest quantitative easing program (see Fed Policy Change above). We are also nearly five years into the Bull Market and expansion that began in 2009. The average expansion historically has been approximately five years.

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Bottom Line

While the recent vertical advance from the early February low is likely to invoke fond memories of 2013, investors should not be assuming that a repeat of last year is likely. Based on the factors outlined above, 2014 is expected to feature significantly more volatility than the average year, and certainly higher volatility than 2013. Such an environment is likely to be more suitable to tactical trading and active risk management. This is not to say that equity markets cannot end the year higher (most years do), just that investors should not become complacent in believing such a move higher will be a straight line.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

 

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