After reaching an all-time high on Friday January 26, the stock market has endured two weeks of declines amid volatile trading that has seen wild daily price swings and taken the major indices into correction territory, declining 10% or more from their peaks. It appears that investors have abruptly shifted their focus from worrying about missing out on the equity rally to concerns that stocks are vulnerable to potentially higher inflation and bond yields than they had previously calibrated.
The stock market has emerged from an extended period of low volatility that seems to have taken some by surprise. A bit of history: Going back to 1928 according to Ned Davis Research, prior to the current episode, the stock market had endured 302 previous periods of 5% price declines from peaks or 3.4 per year on average. We had not experienced one since June of 2016 following the Brexit vote. The market has experienced 96 previous 10% declines or about 1.1 per year over the same time period. We had not been subjected to one in over two years since the last episode commenced from the high on November 3, 2015. Though a couple of 1,000 point down days on the Dow Jones Industrials were a shock, and were in fact the two largest daily point declines ever recorded, as far as percentage declines go, they don’t even crack the top 20 down days in history. Monday’s 1,175 point decline amounted to 4.6% and Thursday’s 1,033 point decline was 4.2%. By comparison, the 508 point decline in October 1987 equated to 22.6% and the twentieth biggest percentage move was a 7.0% decline in September 2008.
The current episode seems to be the result of a confluence of factors:
- January’s employment report, released on Friday February 2nd, suggested improving growth and potentially higher inflation. Average hourly earnings increased 2.9% year-over-year, which is the largest increase since 2009. With the labor market tight and the headline unemployment rate at a low 4.1% this report suggested that increasing wage inflation may be on the horizon.
- Potentially higher inflation portends potentially tighter monetary policy. If there is growing inflation pressure in the economy, then the Federal Reserve may be inclined to raise the Fed Funds rate more aggressively than investors had previously thought.
- If inflation is higher and the Fed tightens policy more aggressively, then bond yields may go higher than investors had factored in. Higher yields increase company costs and provide competition for the stock market. Indeed, the ten year treasury yield increased from 2.63% to 2.85% from January 25th to February 8th.
- Politically, there was the threat of another government shut-down, which was averted early Friday morning. Also, on the political front, the Treasury department recently announced the need for greater borrowing. More borrowing means added supply of treasury bonds in the market which tends to result in higher yields if there is not a commensurate increase in demand for those bonds.
- Finally, the selling in the stock market seems to have been exacerbated by trading strategies that depended on the continuation of low volatility, or levered strategies, or both. As these market participants had to unwind their positions as stock market volatility and yields increased, further downward pressure was exerted on stock prices.
It is important to keep the recent activity in proper perspective. Though stock market volatility has increased, it has done so from historically low levels. Also, volatility can be the friend of disciplined portfolio re-balancing. Inflation may rise and bond yields are likely to increase. However, the data suggests that higher inflation is the result of improving economic conditions and the Fed has been trying to engineer higher inflation for years. Global demographics and excess productive capacity seem likely to keep either from getting out of hand in the near future. Most stock bear markets, where price declines exceed 20%, occur in conjunction with economic recessions. There are cases where 20% declines have occurred in the absence of recession, the market crash in 1987 being a prominent example. These cases tend to be sharp, short declines within an ongoing secular uptrend. There is no guarantee that the current market won’t deteriorate further, however the economic data in the U.S. and globally does not support a recession scenario, in fact it has been strengthening, and the stock market has not exhibited the typical signs of a bull market top. Stock market valuations have been stretched, but earnings have been strong and earnings estimates for 2018 have risen dramatically as analysts have factored in the possible effects of the new tax law.
In this environment it is important to maintain a long-term outlook and not be swayed by short-term fluctuations. Currently the stock market stands at levels similar to where it was in November with still healthy gains over the last 12 months. A sound, diversified portfolio strategy should limit any short-term losses while leaving portfolios in a position to profit over the long-term.