As we near the end of the year, investors can look back at a phenomenal equity market performance, with the S&P 500 returning 28.49% YTD (at time of writing). From a dovish Fed to easing trade tensions (temporarily at least), the bulls have found enough reasons to push stock prices higher. Meanwhile, volatility has been unusually low, and there are compelling reasons to believe it will return with a bang in Q1 2020.

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Source: Yahoo Finance

Market participants are too optimistic for 2020’s prospects

In a previous article, the case for a black swan event transpiring at the turn of this decade was established, which will induce havoc across financial markets. Many market participants are getting too complacent in believing that we will continue to witness strong returns next year following a spectacular 2019, and this very complacency should concern investors.

One should acknowledge the fact that this year’s incredible returns followed a horrendous Q4 2018, which consequently set up the market for a strong leg higher from a technical perspective and amid relatively cheaper valuations. Contrarily, Q4 2019 has delivered solid returns for investors amid a supportive Fed and apparently easing trade tensions (at least for now). This time last year, the trailing-twelve-month PE ratio of the S&P 500 was 19.46, presently it is a whopping 25.23, and the forward PE stands at 19.58 (at time of writing).

Therefore, just like how Q4 2018 set the market up for a solid year ahead, Q4 2019 is likely setting up for a rough year ahead for stocks, particularly as the 2020 primaries and the general election get underway. In fact, there is a strong negative correlation of -0.81 between the performances of the S&P 500 of Q4 2018 and Q4 2019. Just like how the downturn in Q4 2018 caused investors to turn more cautious heading into the new year, the surge in stocks in Q4 2019 is promoting complacent optimism going into 2020, with one chief equity strategist even expressing the potential for the S&P 500 to touch 3,950 by the end of next year. That would imply a jump of over 22% next year, something that is very unlikely given the uncertainties surrounding the 2020 elections. Even if President Trump wins a second term, it is not necessarily a rosy scenario for stocks, as it would imply prolonged trade wars with the aggressive use of tariffs.

Market patterns suggest the return of volatility in Q1 2020

Whether one is optimistic or pessimistic about the market trajectory next year, one thing is certain, volatility will return in Q1 2020. An analysis of the patterns of annual equity market performances over the past decade has revealed an interesting pattern. For every year that witnessed heightened volatility in August (a seasonally volatile month) with notable pullbacks, it was followed by a strong Q4 and the return of volatility in the first quarter of next year. The only exception to this trend was 2011, where the August volatility was not followed by the return of volatility in Q1 2012; although 2011 was indeed a unique year given the magnitude of volatility witnessed that year, hence setting the market up for a leg higher going into 2012. The table below breaks down the performances in August, Q4 and following year Q1 for each year over the past decade.

In 2019, investors witnessed the return of volatility in August, followed by a strong leg higher in Q4. According to the trend revealed by the analysis above, volatility is indeed set to return next quarter.

This pattern certainly makes logical sense from a human psychology perspective, given that periods of heightened volatility in August induces investors to turn more cautious going into Q4, and this dampened sentiment sets the stage to better-than-expected equity returns. Consequently, strong returns in Q4 encourage many investors to believe in the optimism going into the next year and this complacency becomes the very reason to provoke the return of volatility in Q1. The most recent episode of this was in Q1 2018. Following solid investment returns in 2017 (19.42%), most chief equity strategists were complacently advocating for the rally to simply continue into 2018 amid a sugar-rush from Trump’s tax cuts in late 2017. This evidently did not turn out to be the case, as investors witnessed the return of volatility in Q1 2018, which was only a preview of what transpired in Q4 2018, causing the S&P 500 to end the year in the red at -6.24%.

Going into 2020, most chief investment strategists appear upbeat about 2020’s prospects, expecting a 5% gain on average, and several expecting around a 10% surge. Nevertheless, this optimism from most strategists and investors is a bear’s best friend, as upbeat sentiment is what tends to set the market up for a pullback. If everyone were bearish on the market, then the resulting cautiousness would inhibit any meaningful pullbacks from ensuing. Hence the presence of complacent market bulls should be considered another important factor in inducing the return of volatility in Q1 2020.

Bottom Line

Following the solid equity returns of 2019, do not buy into the naïve optimism conveyed by various market participants. The strong performance in Q4 2019 has set the stage for the return of volatility in Q1 2020, as we head into an election year. Just like how the late 2017 tax cuts failed to deliver strong market returns in 2018, the late 2019 Phase 1 trade deal will prove insufficient to support the market higher in 2020, as trade uncertainty is far from over. Position wisely amid expensive valuations and sentiment favorable to the bears’ case.