Notations From the Grid (Weekly Edition): On the Recent Stock Market Sell-Off
4 Things to Know About This Market Pullback
The stock market has pulled back in recent days, with U.S. equities posting their largest drop in two years. The size and speed of the selloff may feel alarming, but there's no cause for panic. We believe conditions are more positive than the reaction of the past few days would suggest, which is why we think this is a short-term respite within the ongoing bull market. Here are four things to know about this pullback:
1. The source of this selloff isn't sinister. We think there are two primary drivers behind the decline:
| Rising rates - Interestingly, it's actually good news behind the market move. A 17-year low in unemployment and continued solid job growth have begun to spur a lift in wages. Last week's jobs report showed that, after averaging 2.2% growth since 2010, wages increased at the strongest rate since 2009. This, however, began to foster fears of rising inflation, leading to concerns that the Federal Reserve will tighten policy faster, sending longer-term interest rates to their highest level since 2014. Stocks have reacted negatively as expectations of higher rates have been re calibrated across equity market values. |
| Pent-up selling - It had been more than 400 days since the last 5% pullback. In fact, the largest drop in 2017 was just 2.8%. With stocks delivering strong, steady gains over the past two years, with no noteworthy dips along the way, we think this selloff is likely being exacerbated by pent-up selling demand and short-term profit taking. |
2. We've seen similar knee-jerk reactions before. The daily point declines in the Dow appear staggering, but this is not uncharted territory. We've experienced similar sharp reactions in the market in recent years, with short-term selling giving way to healthy rebounds as the dust settled and markets reconnected to broader fundamental conditions:*
| In August 2015, the market fell 11.2% in about a week, with the Dow shedding 1,879 points in six days, including an intraday drop of 1,100 points. The stock market had a return of 12.5% over the next three months. |
| Stocks dropped 12.0% in the first six weeks of 2016, including a seven-day stretch in which the Dow dropped 1,375 points. The market then gained 13.5% over the following three months. |
| Following the Brexit vote in June 2016, stocks dropped 5.3% in three days, including an 871-point drop for the Dow. Stocks posted a return of 8.6% over the next three months. |
We don't think this precludes the market from further volatility in the coming days or weeks, but we do think this dust will settle as well.
3. The fundamentals are actually improving. Over short periods of time, markets can frequently be led by headlines and emotion. But over time, we expect economic conditions and the direction of corporate earnings to drive performance. The U.S. economy is near full employment, consumer and business sentiment has risen dramatically, manufacturing and service activity is at multi-year highs, and GDP growth in 2018 is poised to be the strongest since 2015. Similar trends are playing out around the globe, where recent data suggest economic growth is on the upswing. Equally positive, corporate profits are rising at a healthy clip, with earnings expected to rise at a double-digit pace this year.
Not all market pullbacks are created equal. Corrections driven by emerging cracks in the economic foundation can turn into bear markets as a recession emerges and corporate profits decline. But pullbacks that occur against the backdrop of sustained economic expansion and rising corporate profits - as is the case currently - present attractive opportunities for long-term investors.
4. Perspective prevents panic. Even with the recent decline, stocks are simply back to the level we were at roughly two months ago. More importantly, equities are still up an incredible 47% over the past two years.* We just concluded the longest stretch on record without a 3% pullback. So while this selloff may feel extraordinary, we're coming off an extraordinary rally. The return to more normal levels of volatility may feel uncomfortable, and while we think volatility will be the norm rather than the exception moving forward, we think the broader bull market still has gas left in the tank.
Market pullbacks don't come with an expiration date. But when the market's fundamental underpinnings are strong, we do know that declines are typically temporary. After an extended period of record-high stock prices and record-low volatility, the current dip offers an opportunity to:1. Review your situation, comparing your portfolio and your progress to your goals to ensure you're still on track.
2. Reassess your tolerance for risk, making sure you're comfortable with your level of risk and that it is aligned with your long-term strategy.
3. Rebalance, where appropriate. Staying the course may mean no action is necessary. At the same time, we think the market's decline is creating an attractive opportunity to rebalance to the mix of equity and fixed income appropriate for your situation, including (where appropriate) capitalizing on the pullback.
Your financial advisor understands what's important to you and uses an established process in partnering with you to help keep you on track. Working with him or her will help you understand how this market reaction may impact your situation and actions you can take to stay well-positioned toward your goals.
Craig Fehr, CFA
Investment Strategist
*Source: Bloomberg, S&P 500 index total return. Past performance is not a guarantee of what will happen in the future.
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