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Market strategists explain why spiking volatility ‘makes sense’ right now

Ryan Detrick, LPL Financial Chief Market Strategist, and Frances Stacy, Optimal Capital's Director of Strategy, join Yahoo Finance Live to discuss market volatility tied to crude oil and the Fed's monetary policy on inflation, interest rate hikes, and stocks handling geopolitical tensions like Russia-Ukraine.

Video Transcript

[MUSIC PLAYING]

BRAD SMITH: Welcome back to 'Yahoo Finance Live' everyone. Just seconds away from today's closing bell. Brad Smith here with Rachelle Akuffo, and Emily McCormick. And standing by for analysis of today's session in this hypersensitive trading week that we've had, we've got Ryan Detrick, who is the LPL Financial chief market strategist, and Frances Stacy, who is the Optimal Capital director of strategy. Great to have you both. We're going to come back to both Ryan and Frances in just a few moments here.

Take a look at the major averages here, as we are going into the closing bell, you've got the Dow Jones Industrial Average right now down 0.7%, 243 points in decline on the day. The S&P 500, that's down by about 0.75%, NASDAQ 1.3%.

[MUSIC PLAYING]

Here's the closing bell.

[BELL RINGING]

EMILY MCCORMICK: And that is the closing bell. We made it, guys. It's Friday, February 18th. And taking a look at where stocks are going to settle today's session, a lot of red across the screen. The NASDAQ composite down about 1.2%. And making our way up the screen here, the S&P 500 down by 0.7%. The Dow Jones Industrial Average down by more than 200 points or about 0.7%.

Now, let's head back over to our panel. Do want to let you guys know that we are awaiting remarks from President Joe Biden slated to begin any minute now on the Russia-Ukraine tensions. But with that in mind, Frances, I'll turn this first question over to you. With the volatility that we saw over the course of this past week, how much of this do you think was in response to the uncertainty now about Russia and Ukraine, and how much do you think is still investors digesting what may be the Fed's next move?

FRANCES STACY: I really think most of the Russia-Ukraine volatility occurred in the energy space, particularly with oil. I think the rest of the volatility in the broader market has to do with the Fed tightening conversation. Now a number of firms are coming out with a prediction that we're going to hike seven times this year. We're now starting to put a balance sheet reduction on the table. We're now having conversations around potentially a 50 bps hike in March, which I don't-- those expectations have come a little bit off in the swaps market but you know, we're looking at this sort of aggressive tightening against this backdrop of inflation and I think that that's what's causing the volatility.

EMILY MCCORMICK: And Ryan, we often go to you and to LPL Financial for historical data on stock performance under certain scenarios. What does past performance suggest about how stocks may handle geopolitical tensions like what we're seeing with Russia and Ukraine?

RYAN DETRICK: Yeah, guys. Thanks for having me, and TGIF, right? Well, you're right, I mean, historically, we went back and found more than 20 major geopolitical events, going all the way back to World War II, and the funny thing about it, stocks pull back about 5%, after about three or four weeks you kind of make up those losses. So we're not ignoring the major geopolitical events that are really swirling in our world right now.

What we are saying is if the economy is strong, look at the housing data, look at the recent retail sales data, look at this earnings season, that's been extremely strong. This volatility we are seeing like we just kind of talked about after a huge rally could be perfectly normal and the geopolitical, the cherry on top to really add to it. But from an investment point of view, we would think that a little more volatility but any major bear market or is this the end of the bull market? No, we don't think so and history would kind of side with that.

RACHELLE AKUFFO: And Frances, as I bring you in here, obviously, we're still seeing a lot of reaction from the markets with every change that we see in that geopolitical situation with Ukraine and Russia. Why do you think given the limited exposure directly to the US and the US economy that we're still seeing a lot of this volatility and it's not really priced in at this point?

FRANCES STACY: Tough question to answer. I mean, I don't know what's going to occur there. If you kind of drown out some of the noise in the news cycle, you look at the technicals which is my favorite thing to do, the NASDAQ has been trading in a range from 13,100 to sort of the 14,300 area for weeks now. And I think it's more around the Fed conversation than anything else. If you look at the S&P 500 and the NASDAQ, they're holding the lows for this year thus far. So if we make a higher low here, we just have to see the strength in that bounce.

I do have to say that with regard to the previous comments, there are some anomalies that we should calculate in based on history. Number one, when they hiked rates starting in December '15 through the end of '18, they hiked nine times but they did it over that three-year period. When you talk about hiking seven times in one year, it's that rate of change aspect that starts to hit the markets. And markets will start to try and price that in the best they can but what they can't price in right now is a lot of credit risk. And so you have the situation where you could see these credit spreads blowing out.

The other thing that you have that's quite an anomaly from COVID is you have the comparisons from the second quarter. You've got GDP coming down and then you've got a couple of percent being taken off additionally against the decelerating comparison because of the negative $1.3 trillion in fiscal drag this year without any laws being changed.

And so we are coming into an environment where you're compressing a business cycle with very large numbers into a very small tract of time and that will exacerbate volatility. So I agree, the Russia-Ukraine situation, yes, it's a situation, certainly, if we go in there and have a lot of attacks but this stock market over the decades has survived as my friend on the panel has said, has survived a lot of these geopolitical tensions. What this stock market is not going to do well with is the Fed tightening into a decelerating economy and history has also proven that.

RACHELLE AKUFFO: Now, Ryan you're saying that when you add up all these things, whether it's inflation, rate hikes, Russia-Ukraine in the news, you're saying it's important to remember that we were just simply-- look, we're just simply due for more volatility in 2022. Give us your analysis on that and what might perhaps shape that?

RYAN DETRICK: Yeah, you're right. I mean, so this is a midterm year, right? We were talking about this a couple of months ago, saying midterm years are the most volatile in a four-year cycle. You see a 17% peak to trough correction in your average midterm year. The first two quarters of a midterm year out of the whole four-year presidential cycle are like two of the worst quarters. So the fact that we're kind of weak here and volatile, you can-- the news is the news, we're not ignoring it but it kind of makes sense.

And you talk about the whole hiking rates thing, I mean, the Fed hiked rates eight times in 2004. The Fed hiked rates 17 times in 2004, '05, and '06. The S&P was up all those years, not up a lot I'll admit, but they were higher. And the idea that the economy is decelerating, we had a 5.7% GDP last year, we're probably going to have 4% this year. So no question, the economy is weaker than last year but 4% GDP this year we think is possible with 10% earnings growth, that's still above long-term trends.

So there's all these swirling things that are out there. It's not easy, investors need to realize after the run we've had more volatility makes a lot of sense. But think of this, when you look at the first Fed rate hike the last seven times, one year later, the S&P 500 was higher six of those times, up about 10% on average. So just because they're hiking, more volatility yes, into the bull market, we'd say probably not.

BRAD SMITH: OK, so considering that historical context, Frances, for the market to have its Gloria Gainer, I Will Survive Moment when that does hit, people want to know where they should be investing into to set themselves up for when we do have that recovery.

FRANCES STACY: Yeah, I'm a little bit more conservative, just in the sense that we're also talking about a balance sheet reduction. The balance sheet has risen to 35% of the GDP and they're talking about correcting the balance sheet down to 20% of GDP in a very short span of time. And I think that's actually going to have a bigger effect than hiking rates. We've never seen a $9 trillion balance sheet and those effects from COVID. So remember after the nine hikes in 2018, we had the 20% correction, but we also had a liquidity crisis in September of '19 when the overnight rate in the repo market skyrocketed pretty drastically around those corporate tax payments.

So that's the challenge really, whether in the short-term here could we see the markets holding some higher lows here and the technicals set up for a rally? Sure. I'd like to see the S&P closing again above 4,772. And maybe that occurs kind of watching the economic data come through. And while GDP is historically high, it's decelerating at the fastest rate of change ever. So then we sort of get into that debate whether the pure level matters or the rate of change?

Furthermore, I heard another analyst, no names, talking about rates in the '80s and the Volcker days. Well, if you look at the amount of debt in the system in the Volcker days, Yes, interest rates were immensely higher but they weren't the huge, huge trillions of dollars that we're dealing with in debt markets. And so these little percentages actually move a lot more money around the system.

You also have commercial and industrial loans, which have kind of fallen off of a cliff. They've had a recent uptick but there are several liquidity drains happening in the market right now. You've got the fiscal drain, you've got the monetary policy aggressively tightening, you've got lending that's going down. And so you're just talking about removing a lot of liquidity from the system.

I think in the shorter term we could have a technical setup to go up. We could go up and make a lower high and fail, we could go up and have a double-top to all-time highs and fail. I don't see a catalyst for taking out the all-time high yet in the system with all of this liquidity coming out. We have to see what that does to credit markets first.

BRAD SMITH: Ryan, on the other side of that, do you see us taking out the lows of 2022 that we've already seen thus far? And particularly, at a time where we still have a few more earnings to get through, especially in the broader retail space, where we're waiting for some of those brick and mortar companies.

RYAN DETRICK: Yeah, when you look at the S&P 500, we'd say probably not. That January 24th flush low. It is concerning though, we're seeing a lot of the NASDAQ stocks starting to break down and a lot of small-cap stocks have already kind of started to break down. So there are clear concerns like we're talking about.

And that's a great point about the credit markets and spreads. I mean, we are starting to see some high-yield spreads breaking out to the highest levels we've seen in a while. The smartest guys in the room I think are the credit markets. It's not blowing out high but again there is some stress in the system. So let's not ignore that. But again, overall market sentiment is pretty dour, rightfully so. There's not been a lot of great news, the headlines are scary. Remember, when the expectations are lower, get any good news.

What could catapult us to new all-time highs? I think it's stronger than expected earnings but also maybe the Fed isn't quite as hawkish as they're making it sound, instead of seven or eight, maybe you get four or five rate hikes. It's kind of the base case we have here. Again, it's going to be rocky and volatile but we still are optimistic we can get to about 5,000 on the S&P 500 when this year is all said and done.

EMILY MCCORMICK: All right, we shall see if we break to that level. Ryan Detrick is LPL Financial chief market strategist, and Frances Stacy is Optimal Capital director of strategy. We thank you both so much for your time.