Greetings! I hope and trust that this finds you well and enjoying life. I’m sure that all eyes have been on the market this week so I felt the following might be useful.
It’s likely that mainstream news will gravitate to headlines of ‘largest point drop in history’ in reference to the declines of Dow Jones Industrial Average reaching 1500 (which is true). What isn’t discussed, however, is the far higher starting point of over 25,000, compared to the last notable low nearly a decade ago in March 2009 around the 6630 level. As such, a thousand to fifteen hundred points today represents only a few percentage points after an extremely strong stretch of performance (and near-30% gains last year alone for the DJIA). Insofar as the S&P 500 goes, 2017 did not feature a single negative month of performance and including January, equity markets had gained in 22 of the last 23 months.
From a practical standpoint, we know such a winning streak is welcome when it occurs and is easy to take for granted, but the fast trajectory is not sustainable indefinitely, nor are stretches of extremely low volatility. A three-steps-ahead and one-step-back are generally healthier in keeping exuberance in check, although one might argue exuberance for the stock market has remained restrained, even with its success, as recent memories of the financial crisis are hard to erase and some level of skepticism persists. Based on data over the last hundred years, pullbacks of -5% or so are to be expected about once per quarter, those of -10% about once a year, and the -15% variety have roughly occurred biannually. We’re certainly on borrowed time for a moderate pullback and have almost matched a record length of time without having one.
When momentum runs for an extended period of course, the tipping point for a market correction and catalyst needed for generating one become far more sensitive. What is the current catalyst? Interest rates. We as investors have to be careful about what we wish for. Seeing signs of stronger economic and stock earnings growth, driven by better fundamental conditions, tax cuts, and business activity has been a key hope by many economists and strategists over the past several years. The drawback however, is that such strength can create the sometimes-tricky byproduct of higher inflation. Any indications of inflation picking up (in terms of pace of wage gains overall inflation remains quite low) can cause bond market interest rates to pick up as well. These higher rates could also be overdue, as the Fed has worked to normalize monetary policy by removing the artificial stimulus that characterized the past decade of extremely low rates. On the flip side, there remains ample demand for U.S. bonds due to low-interest rates in other developed countries and equity market shocks tend to push investors from stocks to bonds—lowering rates and closing the circuit somewhat.
All-in-all, there are not a lot of surprises here. Market pullbacks based on fundamentals should be healthier and less damaging than those driven by a geopolitical shock such as war or terrorist activity, or due to the more extreme case of heightened recession fears. Last year represented an especially strong year for stocks, where it was difficult to find data that wasn’t showing signs of improvement. This is still the case however, the better conditions get, the harder it is to improve further—this may be one of the key hurdles we face in 2018.
If you have questions about any of the above or feel that we can help in any way don’t hesitate to contact us.
Jeff Christian CFP, CRPC
Believe deep down in your heart that you’re destined to do great things.