By: Herbert Diamant
Something is happening in the markets that represents a material change. Specifically, market volatility has intensified in ways that traditional measurements, including the VIX index, are failing to fully capture, with daily market swings exceeding 1% becoming the new normal. This volatility stems from an interconnected set of economic and policy challenges: stocks priced at historically high valuations, an administration pursuing rapid policy changes, controversial trade tariffs affecting consumer prices, unresolved immigration policy affecting 11 million undocumented workers who strain public services while remaining in economic limbo, and a Federal Reserve monetary policy that appears disconnected from market realities
The market has been both volatile and rangebound since Trump was reelected in November 2024. The swings have become more pronounced, where a new normal is observing daily moves in the market indexes that are over 1% both up and down. Part of the reason for this is that fundamentally, many stocks are “priced for perfection” at a frothy valuation. Over the last two years, stock indexes have moved up nearly 50%. As corporate earnings did not collectively increase 50%, investors were buying stocks regardless of their intrinsic value. These higher share prices are at a point where many stocks we review are overvalued, suggesting lower returns going forward. Seasoned analysts from Goldman Sachs see a period of 3% returns, something much lower than investor expectations.
Why the current market volatility? Some believe the markets must move higher this year because Trump is a pro-business president, but the markets factored this in during the November election. There is the prospect of lower taxes, a smaller government, and less regulations. To reduce the size of government, the Administration is using the entrepreneurial process of making changes by moving fast and “breaking things,” something never tried before. Over the near term, this process causes uncertainty for many companies doing business with U.S. government agencies.
Others see a lower stock market from imposing large tariffs on imported goods. When these goods arrive in the U.S., the tariff is charged not to the targeted country but rather to the company that purchased the goods. The impact is that their costs of goods are raised, and they typically pass this cost along to their customers. Conceptually, a tariff will reduce purchases of imported goods over time and increase U.S. production of these items at higher prices. The immediate impact is higher prices, which create further inflation throughout our economy. This will be seen in grocery stores, especially with fresh fruits and vegetables. Also, tariffs will affect new automobiles and auto parts. With 60% of crude oil imports from Canada, those tariffs could raise prices for gasoline, home heating oil, and jet fuel, which impacts nearly every part of our economy.
Another factor causing volatility is illegal immigrants. When our borders were opened, no policy thought was given to what would eventually happen to these immigrants, who remain on the bottom rung of employment with no path to citizenship. There are over 11 million undocumented immigrants who are negatively impacting our economy because they do not pay taxes yet still place great strains on sectors that include schooling and health care. While mass deportation is one option, practically speaking we need to properly think through a solution for hard-working immigrants who are striving to reach the American dream.
Then there is a perplexing monetary policy. Last September, the Federal Reserve dramatically cut interest rates by ½% to 4 3/4%. They felt inflation was under control and the job market was slowing down. Neither event has occurred. Their economists still measure inflation by excluding energy and food components. Those of us who must pay for food and energy costs do not need an economics degree to feel the sustained, sticky inflationary pressures. The bond markets came to the same conclusion, as the interest rates on the benchmark 10-year treasury increased by over 1% since these rate cuts.
To summarize, sources of market volatility come from many places. Price fluctuations in stock prices normally result from either company or specific industry news. However, we are in a period where geopolitical turmoil, and uncertainty in fiscal policy and monetary policy, injects a trifecta of added volatility. As investors, we cannot change these issues. Moving forward, we continue to practice our conservative approaches that have worked through many decades of market exposure. We maintain a conservative approach towards asset allocation into the stock market, along with diversification among industry sectors, and holding high quality stocks within each sector. Despite this near-term volatility, these are interesting times that hold great long term potential for a strengthening economy, and that is what really matters.
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