7 considerations to make the most of market volatility

Implied volatility is also higher. The S&P 500 needs to move 1.5% in either direction daily for the next month to justify the currently level of the Volatility Index (VIX) versus just an 0.8% daily move two weeks ago.

We believe these changes are driven by three main factors that drove investors to flee crowded positions: 

1. Growth scare: There is a higher risk of recession now than there was just two weeks ago. The jobs data released at the beginning of August were weak and triggered the “Sahm Rule,” which has coincided with every recession since 1970. We don’t believe the economy is currently in recession, and still believe the most likely outcome is continued expansion. Layoffs are low, corporate profits are rising, margins are healthy, and output is solid. That said, the Fed likely doesn’t have the flexibility to wait and see. We think it’s on the precipice of a material easing cycle. The message for investors is clear: Cash is likely set to underperform bonds, as it has in 11 of the 12 easing cycles over the last 50 years.
2. AI skepticism: There is more skepticism around the earnings benefits from artificial intelligence. Earnings season from the perceived “AI winners” was solid yet unspectacular. This is part of the problem. Investors had grown more optimistic that AI would start to show a more pronounced return on investment. If there was an “AI premium” embedded in the market, it is largely gone. The tech-heavy Nasdaq 100 is now underperforming the broad market year-to-date. The forward price-to-earnings ratios for three of the four “hyperscalers” are lower now than when they were at the start of the year. We believe AI has the potential to drive meaningful economic, productivity and earnings benefits over the next decade. The stocks that could be best positioned to benefit are trading at a premium to the market, but don’t look too stretched relative to their own history.
3. The U.S. election: Long-term investors are probably best served to focus more on strategic asset allocation and implementation decisions than shifting perceptions of election outcomes, but they do seem to drive markets in the short term. Since the middle of July, implied election odds have moved back to an effective toss-up from the previous greater-than-70% chance President Trump would be re-elected. The stock market is not reacting to one candidate or another as much as it is reacting to a more uncertain outlook for the outcome in November. That necessitates lower valuations.

We still have a constructive view on markets despite a more pronounced risk of a more material growth slowdown. As we move through the end of the summer and into the fall, we will likely view increased volatility as an opportunity to put money to work across asset classes.

Spotlight: Seven considerations to make the most of market volatility

Market volatility may be normal, but it should still spark action. In the rest of today’s note, we list seven approaches we think investors can consider make the most of the sell-off. 

Revisit your plan. Use this period of market volatility as an opportunity to revisit a comprehensive wealth plan. This ensures that financial goals are clearly defined and aligned with your long-term objectives. When portfolios are properly aligned with intent, it is likely they are also designed to withstand this type of volatility. Don’t have a plan? Use the sell-off to put a holistic plan in place. It could help relieve the trepidation associated with the next one.

Rebalance your portfolio. Review and rebalance portfolios to maintain your strategic asset allocation. Equities have pulled back and fixed income has rallied, which may result in unwanted drift. Earlier this week, to maintain proper levels of exposure, we added to equities in portfolios that we manage on behalf of clients.

Put idle cash to work. Using stock market pullbacks to increase equity exposure can be a prudent strategy. Average returns for the S&P 500 12 months after a 5% pullback are nearly 12%, and markets are higher nearly 75% of the time. Don’t know where to start? Consider funding trusts, Roth IRAs, UTMAs or 529 plans during market downturns. These types of accounts typically have longer time horizons that should reduce some anxiety about trying to time the market. Still nervous? Consider structured investments, which offer the potential to participate in some market appreciation with embedded downside protection.

Lock in yields. Treasury rates are falling fast now that it seems likely the Fed will cut rates. Tax-equivalent yields in municipal bonds for most taxpayers are still above 5%, but may not be there for long. History suggests that if you invest one month before the Fed starts cutting, average 12-month returns in municipal bonds are over 300 bps higher than if you waited until one month after the first cut.

Tax-loss harvest. Investors don’t have to wait until December. Consider offsetting gains and reducing your tax burden. This can be particularly effective during periods of market downturns. Investors can also explore using managers that actively manage tax losses on an ongoing basis.

Transfer assets and consider paying taxes now. Moving assets off of your personal balance sheet can be more tax-efficient when they have depreciated. The idea is that future appreciation of these assets will occur outside of your estate, potentially reducing estate taxes. Make the most of annual exclusion and lifetime gifts. Consider funding grantor retained annuity trusts (GRATs) with depreciated assets, or swapping assets into a grantor trust, if you anticipate a market recovery. If you are considering converting a traditional IRA to a Roth IRA, a market dip may be the opportune time. Similarly, public and private corporate executives ought to consider exercising their options, as it could be more tax-efficient to do so when stock prices are low. Investors should consult their tax, legal, and accounting advisors when considering engaging in financial transactions.

Keep things in perspective. The stock market has returned nearly 12.5% this year and has sold off by 6% from prior all-time highs. The average year that ends with a gain comes with an 11% peak-to-trough drawdown. The cost of outsized returns from equity markets is this type of volatility. Also, if the bull market that started in October 2022 is really over, it would be the shortest on record. Instead, it seems more likely to us that this bull market will extend toward the median gain of 110% over four years from its current length of 40% in less than two years.

Volatility can be uncomfortable. Your J.P. Morgan team is here to help you make the most of it.