In a previous article, I discussed why risk in the financial markets is similar to a forest fire. While firefighters may feel the temptation to extinguish every fire they come up against, all that does is create a dangerous buildup of dry kindling and dead wood that will provide fuel for an even bigger inferno. Similarly, while artificially depressing volatility may benefit some investors in the short term, in the long term, it creates a buildup of systemic risk that can threaten the whole stock market. Periods of low volatility are followed by periods of high volatility.
A recent note from Morgan Stanley (MS, Financial) explores a number of reasons why investors may be in for more volatility this summer than they may otherwise expect.
It is widely believed the Federal Reserve will cut interest rates at its next meeting. While such events have generally been good for investors, the note argues this may not be the case this time around:
“This time may be different. While rate cuts have been positive for equity markets historically, there are times when the Fed’s cuts don’t work. Specifically, if the Fed is beginning a new full-blown rate cycle, equity markets tend to respond negatively until the Fed can get ahead of the slowdown.
In other words, if the U.S. economy is about to enter a recession, the initial Fed cuts are typically viewed poorly by stocks. We think the risk of a U.S. recession starting in the next 12 months is high, as high as it’s been since 2007, and while we don’t expect the next recession to be nearly as bad as the last one, it is likely to have a negative impact on stocks over the next three to six months.”
The second source of summer volatility could be company earnings. Frequent financial disclosure has made analysts pretty good at forecasting short-term earnings. Long term, these forecasts tend to break down:
“Secondly, companies tend to be pretty good at managing earnings in the short term, meaning the current quarter. However, their ability to forecast their earnings over the intermediate term has proven to be less accurate. Part of this is due to their ability to see macro-slowdowns, or accelerations. Therefore, with our view that a recession is looking more likely over the next twelve months, it’s also likely that company earnings guidance for the next 12 months is too high.
Given the significant deterioration of the macro-date in the past few months, and the fact that we are past the halfway point for the year, we suspect that companies may feel the need to lower their optimistic full-year earnings guidance provided back in January”.
In other words, full-year targets were set at a time where most management likely did not anticipate an economic slowdown (as this is not really what they are supposed to do anyway). Accordingly, investors may be hurt when these estimates are brought down.
The third source of volatility is the simple fact the third quarter is often the weakest one of the year for equities. The bottom line for all of this is there could be a stock market downturn on the horizon:
“As a result of these factors, we expect a 10% correction for global equity markets with potentially worse outcomes for stocks that are crowded and that have performed well over the past year. This would include high-quality stocks, and even some defensive areas that are now overvalued. Therefore, we continue to recommend investors wait for this correction before putting spare cash to work, rather than trying to trade the day’s events and headlines”.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Sam Zell: Try to Avoid Competition
- Corporate Debt Is a Time Bomb
- Will a Trade Truce Stave Off a Recession?
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