After an unusually long period of steady positive performance and no dips of even 5%, volatility came roaring to life in early February. The speed and magnitude of this awakening caught investors unawares and ignited a fear that prolonged market losses were on the horizon. Selling took hold. Now, investors are left wondering what’s in store for the near term.

A CRASH COURSE

2017 was a year of tranquil markets and positive returns and 2018 began where 2017 left off; the S&P 500 enjoyed the best January performance since 1997, capping off a string of 15 months of positive performance, a market feat never seen before. Coinciding with the positive returns was an environment that was abnormally calm. Volatility was extremely low in 2017; the market rose for 83 weeks without a pullback of even 5%, and more than 100 weeks without a larger, 10% correction. But that all came to a halt during the first few days of February. US stocks declined by over 10% and volatility more than doubled as the VIX went from 17 to almost 40 in a single day.

INFLATION AS A CHANGE CATALYST

The sell-off was triggered by fears of rising inflation stemming from a stronger than expected January labor report and confirmed by the core CPI reading (Display). These data rose more than expected, solidifying the market’s concern that inflationary pressures are building in the economy. But this mounting inflation is consistent with an economy operating at capacity. And we expect the trend will likely persist, but the rise in inflation will be more gradual than the sharp increase reported for January.

The market is also concerned that rising inflation will trigger a more aggressive Fed. We forecast four Fed rate hikes in 2018, a prediction the market is moving towards, but we believe rates are still low enough that an increase should not derail the equity market. Strong fundamentals—low unemployment levels, double-digit corporate earnings growth, and robust manufacturing reports—should continue to support markets ahead. We believe these factors illuminate a solid economic framework, and rising rates will not create a major headwind for growth. While these fundamentals argue for investors to stay invested and not try to time the market around volatile moves, there is a more compelling rationale for maintaining equity market exposure during tumultuous times. When markets decline, they seldom stay down for long.

NOT A SURPRISE

The sell-off and related volatility were not unexpected; in fact, history tells us they were overdue. As unsettling as they are, market corrections are somewhat common. During the last 37 years, US equities were hit by a peak-to-trough decline of at least 10% in 20 of those years (Display). Despite these corrections, stocks posted negative returns in only six of those 20 years; the other 14, they were positive. And when they do decline, stocks don’t stay down for long. Historically, after a decline of 10%, it takes just 10 weeks to recover and surpass the prior level.

CORRECTIONS = OPPORTUNITY

It’s not easy to stay invested during market turmoil, but history shows that market timing rarely works and dips do not last long before markets return to growth. Although it might sound counterintuitive, market corrections often offer the opportunity to capitalize on market overreactions. Market turbulence opens the door to take advantage of lower valuations by tactically moving to different opportunities. These tactical moves require an active manager who can identify well-managed companies with sustainable margins driven by solid business models. And it is often during these times that strong companies pull away from weaker ones, a distinction that creates an opportunity.

For more on trends in the economy, markets and asset allocation for long term investors, explore The Pulse, a Bernstein podcast series, and for additional thought leadership, check out the related blogs here.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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