The extreme market volatility, particularly in options and equities, that has hit the market so far this year is becoming so serious it is raising concerns not only among investors but even among regulators.

The US and European equity markets have reversed their gains since the start of the year as a result of elevated valuations. Forward price-to-earnings for US equities and a number of other markets have been trading at top of their 10- to 15-year range.  Credit spreads, whether for investment grade or high yield, have approached their pre-pandemic lows.

The recent GameStop controversy, involving short-selling by hedge funds and a short-squeeze by retail investors, has exacerbated the situation.

“This is fueling investors’ concerns that markets are getting overheated,” says Tai Hui, chief Asia market strategist at J.P. Morgan Asset Management. “The extreme swing in selected stocks due to retail investors’ participation, resulting in a short squeeze of some hedge fund positions, added to this worry.”

In addition, the flow of news has been unrelenting, with significant economic and market-related developments occurring on an almost daily basis. “It is no surprise, then, that the dispersion of returns between different geographies, styles, sectors and asset classes has been extraordinary,” according to LGT Vestra.

The situation has raised concern even from the US Securities and Exchange Commission (SEC), which issued a statement last week (January 27) saying: “We are aware of and actively monitoring the on-going market volatility in the options and equities markets and, consistent with our mission to protect investors and maintain fair, orderly, and efficient markets, we are working with our fellow regulators to assess the situation and review the activities of regulated entities, financial intermediaries, and other market participants.”

The statement was obviously an attempt to reassure the market but there seems to be no substantial change in the levels of volatility so far this week.

However, Graham Smith, an independent market commentator in an article published by Fidelity International, reminds investors that the long-term outlook should not be affected by the recent events.

“It’s important to remember though that the outlook for this year as a whole will have been little changed by the events of the past week. A further, short period of negative economic growth seems almost certain given continuing lockdowns; however, growth could bounce back very sharply in the second half of the year amid a release of pent-up consumer demand and as government stimulus programmes get to work. The IMF this week upgraded its forecast for global growth in 2021 to 5.5%, from the 5.2% rate it had predicted last October,” Smith says.

Disciplined investing

In any case, market volatility requires investors to be disciplined in two ways. First, investors need to rebalance portfolios according to their financial objectives.

Assuming investors had the correct equity/bond allocation ahead of the equity rally since October, the outperformance in equities would require investors to reduce equity/add bonds so the portfolio returns to the appropriate allocation.

It should be noted that the fixed income allocation here should be broadened to corporate credits and emerging market debt (EMD).

“The limited movement in developed market government bonds, especially US treasuries, reflect that they are less effective to provide protection against market corrections than before. While corporate credits and EMD have a positive correlation with equities, their income component provides a consistent cash flow during moments of volatility, even if their nominal bond price can also swing with varying market conditions,” says Hui.

The second discipline is diversification. While selected markets and sectors are expensive relative to forward earnings and book value, not all markets are in the same position.

“We have advocated investors to be more diversified this year, both by region and by sector, given our expectation of a more comprehensive recovery from Covid-19. On top of keeping US, China and technology as long-term structural allocations, investors should take a closer look at Asean, Europe, EM ex-Asia. For investors who have under-allocated into equities, any upcoming correction could be an interesting opportunity to add,” says Hui.