The S&P 500 plunged another 4.1% today, wiping out gains for the year as investor anxiety grew in the wake of last week’s losses. As of this evening, it appears U.S. stocks will open lower when cash trading resumes at 9:30 a.m. ET on Wednesday. It appears, but is by no means certain, that things may get worse before they get better.
Such market moves are nerve-wracking for sure, but I still believe that this is not the beginning of a bear market in the U.S. A significant pullback actually may prove quite therapeutic since investors had arguably become too complacent in recent years.
I thought it might be helpful to provide advisers answers to what are likely some commonly asked questions.
Q: What is going on? Why have markets suddenly turned so volatile?
- Although pinpointing an exact cause(s) is virtually impossible when dealing with a complex system such as the stock market, a reasonable trigger for the sell-off may be signs that U.S. workers’ wages are growing at a faster than expected pace. This does not necessarily mean that inflationary pressures will rise, but economic models that the Federal Reserve (Fed) uses will suggest that interest rates (the Fed controls the short-term “federal funds” rate) will need to go higher in an attempt to “cool the economy”.
- The pace of the decline Monday afternoon also suggests trading programs tied to volatility may have helped exert additional selling pressure on equities.
- Additionally, the prolonged period of low volatility and gains in stock prices (the S&P 500 rose in 14 out of the last 15 months!) left the market vulnerable to a reversal in investor sentiment.
Q: Is this just the beginning on a deeper correction, or even a bear market?
- Not necessarily. By most indicators, the U.S. (and much of the global economy) remains in relatively good shape.
- The Atlanta Fed’s GDPNow forecast model now predicts annualized growth of 5.4% in Q1. In addition, corporate earnings remain solid, job creation is relatively robust, fiscal policy is expansionary, and inflation expectations, though well off from 2016’s lows, are still below long-term averages.
- I can’t imagine a bear market scenario (>20% drop from recent high) with such positive economic indicators. Of course, a 10%+ correction is certainly not out of the realm of possibility.
Q: What is the key risk(s) going forward?
- I believe a key risk is the Federal Reserve raising its target for the federal funds rate too far, too fast. My guess is that newly installed Fed Chairman Jerome Powell is probably well-aware of this risk.
- It appears to me a similar scenario to the beginning of 2016 when markets reacted negatively to signals from the Fed that it was prepared to raise the federal funds rate target aggressively that year. The Fed backed off after stocks (the S&P 500) corrected by approximately 11%. The S&P 500 then went on to finish the year up by about 9.5%.
Q: Should I sell now?
- Avoid being impulsive and maintain perspective. It is usually ill-advised to disturb a well-crafted investment plan due to declines that, although stomach-churning at times, are actually within the bounds of normality from an historical perspective.
- Despite recent losses, the S&P 500 has gained 15.3% over the past year and by 13.5% annualized over the past 5 years (not including the impact of dividends). These are returns well above the long-term average.
- Remind investors of the impressive gains that stocks have delivered in recent years.
Q: Is this a buying opportunity?
- It is quite understandable that your clients would balk at putting cash to work in this environment.
- Buying meaningful dips can be quite beneficial but is difficult to do when there is so much fear of further declines.
- Investors who systematically invest, such as in an employer’s 401K plan, should consider continuing as they normally would and take advantage of dollar-cost averaging.
- Investors with large sums to invest, such as a bonus payout, may wish to wait until cooler heads prevail and the market shows signs of stabilizing before putting meaningful sums to work. Consider staggering investments in over a period of months with the understanding that it is impossible to time the market.
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