MC Briefcase: Market Update – Is This a Sign of Further Declines to Come?
With 1000 point swings in the Dow Jones becoming commonplace over the past few weeks, many investors are asking themselves, “What has changed and is this shift a sign of further declines to come?”
Let’s explore some of the factors behind the roller coaster ride of 2018 (so far) –
How severe is a 1000 point decline?
In terms of percentages, the significant point declines of the past few weeks were in the range of about 4.5% per day. During the “Bear” market of 2008, we saw four daily Dow corrections in excess of 7%. As bad as the point totals sound, the percentage declines are less severe than what has been experienced in past corrections. This shows that the economic market backdrop today is significantly stronger than in 2008 by almost any comparable metric.
What factors are driving the recent increase in market volatility after a long period of calm?
There appear to be three clear factors:
1) The expectation that rates will accelerate in the future
2) A fear of higher inflation
3) A massive unwinding of leveraged Short Volatility “bets” in exchange-traded funds
How are future interest rate expectations affecting the market?
Coming off the “Great Recession” of 2008, the Federal Reserve had decidedly kept rates low in order to stimulate the economy. Low rates reduce borrowing costs to make real estate more affordable and make stocks more attractive as compared with bonds. Although rates have recently started to inch up, the benchmark ten-year Treasury still yields only 2.8%. Many experts feel that Treasury rates would have to increase to at least 4%-5% to offer reasonable competition for stocks. That is a long way from where we are now and appears unlikely in the near future.
How is the fear of accelerating inflation moving the market?
Rates and inflation tend to go hand in hand. Higher inflation will generally prompt the Fed to raise rates on a more aggressive basis. After many years of sluggish growth and extraordinarily low inflation, current readings (including wages) are starting to move a bit higher. The Fed has planned to raise rates in 2018 on a slow and deliberate path but many fear acceleration in inflation could cause them to deviate from that path. Although it appears highly likely inflation will be higher than what we have seen the prior ten years, the probability of significant spikes appears to be low based on the most current cost of living measures.
What is the problem with short volatility funds?
Being lulled into a false sense of security over the past few years made many institutional and individual investors feel compelled to make significant bets on market volatility continuing to stay low. Many of their bets were made with borrowed funds (on leverage). As market volatility started to increase these unfortunate “market players” were forced to sell other securities to cover their leveraged bets. It is telling that much of the volatility we have seen in the past few weeks has been at the end of the trading day which is when these types of positions are typically settled. This trend may continue while this unwinding of trades has a little ways to go.
Is economic weakness behind the recent declines?
The stock market and broader economy are not one in the same and a multi-day pullback does not an economic recession make. The fundamentals of the U.S. economy are strong with unemployment at a multi-year low of 4.1% and the housing market on solid ground. Consumer confidence is up and the banking system is much better capitalized than it was in 2008. Never say never on an economic recession – but almost all indicators today continue to be flashing positive.
Did the market go up too far too fast?
Yes. Since the election, the Dow had been up over 6000 points without even so much as a modest correction. Markets have been extremely calm over the past few years by historical standards. These types of corrections are healthy and they put the brakes on over-speculation – allowing investors to take a breather and providing time for corporate earnings to catch up with valuations.
Should portfolio changes be made in response to the recent market volatility?
No one can consistently predict market movements on a short-term basis so changing strategy now could do more harm than good, as reversals can be fast and severe. Even the most successful investors do not try to time the markets. In 2007 Warren Buffet made a bet that an S&P 500 index fund would outperform a carefully selected portfolio of Hedge Funds. At the end of ten years Mr. Buffet’s selection, the S&P 500 index fund, had an average annual return of 7.1% as compared with 2.2% for the selected portfolio of Hedge Funds whose managers were paid millions to outperform the markets through stock selection and market timing.
As always, please do not hesitate to contact Mezrah Consulting if you would like to discuss your specific situation in more detail.