Over the past three weeks, we have seen overall market volatility skyrocket (drastic up/down movements on a given day in the market). Over the last 10+ years, the markets have been relatively stable with movements greater than 1% considered large. While this may seem like the new normal, when looking back at a broader stretch of history, large stock market moves can and do happen. Below is a primer on market fundamentals that help to explain the recent market volatility.
Market Equilibrium
Investment markets are places where shares of companies or debt obligations are traded. There are few new products being created in the market, so the price of a stock/bond is determined by the value that two parties are willing to trade that position/holding. If a stock trades at $100, it means one person thinks $100 is a great price for the stock and wants to buy it, where another person thinks $100 is too much for a stock and wants to sell it. This is an equilibrium price.
Stock/Bond Valuation
It is also important to understand how stocks/bonds are valued. There are many nuances to valuations, but we wanted to create an easy to understand summary. Intrinsic Stock/Bond valuations are based on the present value of future cash flows. For stocks, this calculation includes the expected growth or decline of a business as well as the risks associated with that growth. For bonds, the values are driven by the coupon or interest payment, as well as risk factors such as duration (how long until the bond matures), creditworthiness (is the company able to pay back their debts), and prevailing interest rates.
Market Volatility
Market volatility, or daily market movements, happens when the world investors are trying to determine a fair market value for investments. Each day, new information is released and that causes investors to value companies higher or lower. During calm markets, there usually is a narrow consensus of future expectations and how firms are valued. Therefore, stock prices may exhibit a narrow range of trading and appear stable. However, in times of uncertainty, the view of the future has a much wider range of outcomes. With the wider range of outcomes comes a wider range of the value of companies.
Coronavirus and the Markets
We are currently in a market phase of great uncertainty, and therefore high volatility. Every piece of new information that comes out has the ability to move the future economic projections, and therefore the stock/bond market prices can move significantly. As unsettling as the recent market declines are, this is the way the markets work. This volatility (in both the positive and negative directions) will remain until we have greater certainty surrounding the economic impact and the worldwide political responses to the pandemic.
What's Next?
While we should not be comfortable with great market swings, it is important to take a step back and realize why these movements are happening. In addition, using history as a guide, once uncertainty is reduced, markets usually recover and this may happen in a short timeframe. While no market downturn is alike, we believe the best course of action is to continue to stay patient and remain focused on your long-term goals.