10 Reasons Volatility Is Healthy

It is all too easy to portray recent market swings as the product of unhealthy, or even existentially damaging, macro forces. An ill-advised trade war… An out-of-touch central bank… End of cycle jitters… You know the list.

In reality, price volatility is an important feature of a properly functioning capital market for risk assets. As we’ve highlighted several times recently, actual US equity price volatility over the past month is more historically “normal” than most of the last decade. It only feels abnormal because investors and market pundits anchor their expectations on the recent sleepwalking past.

With that idea in mind, we took some time today to gin up a holiday-inspired Top 10 list of “Why we’re thankful for recent equity market volatility”:

#1. It reminds investors that there is still no such thing as a free lunch. US equity investors are up 180% since 2009, with no annual drawdowns and some of the lowest volatility on record over the last 2 of those years. The price churn since early October is a healthy reminder that US equities are meant to be long term investments, not hyper-charged money market accounts.

#2. It makes corporate managements more aware of market signals regarding their performance. When equity markets climb slowly and lift most stocks higher, corporate leaderships may feel they are doing a good job even if they are not. Volatility injects some discipline into management direction and focus. Look no further than many bold-faced US tech names right now to see the start of this process. Even masters of the universe need a wake up call once in a while.

#3. It gives humans a better shot against algorithmic approaches to investing. The latter only knows history and is skewed to the last 100 days. The former knows the last decade or more and can recognize when market conditions are shifting.

#4. It shakes out the weak. Just look at the carnage in crypto currencies over the last week (and year) for a great example of this phenomenon. There used to dozens of cryptos with market caps over $1 billion. Now there are just 10. There should probably be just one or two.

#5. Volatility keeps monetary policymakers and elected officials on their toes. Markets are, in the end, democratic institutions that use prices to place their “votes”. When investors feel governments and central bankers have it wrong, risk asset prices decline. Policymakers must then either change course or explain why their priorities are more important than asset prices.

#6. It can curtail excesses before they reach dangerous levels. Many readers might say the recent volatility is a function of already-formed asset price bubbles, with US stock prices irrationally inflated due to years of loose monetary policy. But even if the Federal Reserve is bent on a controlled demolition of that bubble with its recent hardline stance on a 3% neutral rate, it still beats letting the excesses of the past continue into the future.

#7. Volatility will stress test new robo-advisor business models, none of which have seen a significant market correction since hitting critical mass.The low volatility bull market of the 2010s was the perfect environment for these automated, low touch investment firms. How will their clients respond to the current market? We’ll find out soon enough.

#8. It forces more rational valuations and exit strategy planning at venture capital firms. Is Uber really worth $120 billion in a 2019 IPO? Are there really hundreds of VC unicorns roaming free, just waiting to be bought by big public Tech companies at even higher valuations? Three months ago the answer to both questions was clearly “Yes”, given the performance of public markets. Now, the answer is much less clear. That is a healthy reality check for this frothy market.

#9. Volatility takes the safety net away from “passive” investments. Buying an S&P 500 Index fund looks great when annual returns are +10% and every quarter shows ever-higher asset values. When returns are 5% in a given year and intra-year losses can be 5-10%, that index fund may look a lot riskier to holders only accustomed to less volatile markets.

#10. Volatility enables capitalism to function properly, supporting democratic institutions. Fear of loss needs to be part of the program if you want to leave societal capital allocation to the proverbial “invisible hand”. Otherwise, too much risk-intolerant capital finds its way into inherently risky investments. Then, when the bubble bursts (and it always does), the individuals who lost money lose faith not just in markets but also in government itself. This is one lasting lesson from the Financial Crisis, and we doubt the US needs any more schooling on this count.

Summing up: volatility is painful, but it is also the cornerstone of all financial markets. As much as we’d prefer an easier path, we are grateful for its essential contribution.

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