Equity markets finished lower in what was a volatile week. Worries about rising interest rates, heightened China trade tensions, and other international risks weighed on stocks, resulting in the largest weekly loss for the S&P 500 since March. Weakness was broad-based, with the faster-growing and more cyclical sectors declining the most. Early in the week the International Monetary Fund (IMF) dialed down its growth expectations for this year and next, partly due to U.S./China trade tensions. Adding to the uncertainty were a small number of companies issuing profit warnings, making investors nervous about the upcoming earnings season. The week finished with prices stabilizing on Friday, as tensions between U.S. and China appeared to ease. Inflation also rose less than expected, calming worries about faster-rising prices. Despite all the negative headlines, companies in the S&P 500 are expected to report third-quarter earnings up almost 20% over the past year, according to FactSet. Those positive fundamentals support our outlook for rising stock prices over time. Historically, stocks have declined by 5% or more about three times a year, so this looks like normal volatility. We think the outlook remains positive, and the current dip doesn't seem unusual.
Four Perspectives on the Pullback: Perception vs. Reality
Market volatility made a noticeable return last week, with the Dow falling more than 1,300 points in two days and the S&P 500 retreating about 4.2% for the week. Sharp market moves like this tend to do two things:
- They suggest something dramatic has changed in the investment landscape that seemingly warrants an equally dramatic and immediate adjustment in stock prices, and
- They bring out the emotional side of investing, which can often exacerbate market swings and, more so, investors' interpretation and reaction to those swings.
Last week's moves, while sizable, were not unique. We've seen similar sell-offs before and we'll see them again. What's more important, in our view, is looking through the mania and focusing on the broader implications, which requires separating emotions from fundamentals and perception from reality.
- Perception: The market has plunged, wiping out investors' gains.
Reality: The word "crash" made several appearances in the headlines last week, and while this may be useful in selling newspapers or attracting clicks, it's not an accurate characterization of the market environment. Yes, the stock market fell sharply on Wednesday and Thursday, producing the worst week for equities since late-March. However, this leaves the market just 5.7% below its all-time high – hardly the carnage depicted in the headlines. Moreover, the U.S. market is still in positive territory for 2018, not to mention that the market has returned 10.2% over the past year, 34.5% over the past two years, and 45.8% over the past three1.
Key takeaway: Market declines are never enjoyable, but the perception of this sell-off is not indicative of broader performance. Equities have delivered strong gains for the past several years, and we are now simply back to the level we were at in July. We believe long-term goals should be evaluated through a lens much wider than just the headlines.
- Perception: This sell-off is a sign that the worse is yet to come, marking a new direction for stocks.
Reality: A bear market can't happen without first falling by 5% and then 10%. That said, most 5% and 10% declines don't go on to become bear markets, which we think will be the case this time, as well. Since this bull market began nearly a decade ago, the stock market has experienced 26 5% pullbacks. Five of those went on to become 10% corrections2. And zero of those corrections were the beginning of a new bear market. Nevertheless, each one of those declines was fueled at the time by some prevailing market event that convinced investors it was the beginning of the end. In 2010, the market fell 16% in fears of a double-dip recession. In 2011, fears over the Greek debt crisis drove a 19% drop. Concerns about the Fed tapering its stimulus in 2013 spurred a 6% sell-off, while a correction came from Chinese currency concerns in 2015. 2016 saw a 13% decline due to falling oil prices and a rising U.S. dollar, and then another 5% drop in response to Brexit. And earlier this year the market fell 10% on fears of rising rates. And yet, the market provided an average return of 27.8% over the following year3. To be clear, a bear market will happen eventually, but, in our view, it will need more substance (a recession, a popped bubble, or a material global shock) to bring it about. We don’t think that anything that substantial has emerged in the past week, despite a market reaction that might feel consistent with the contrary.
Key takeaway: Against a favorable fundamental backdrop, market declines present attractive buying opportunities. Eventually we will hit a recession, but in our view, economic underpinnings make that unlikely in the coming year, supporting further increases in corporate profits – a historically successful recipe for the stock market. Going back to 1955 and looking at the years when the economy grew by more than 2% and earnings grew by 10% or more, the market rose 92% of those years, with an average return of 15.6%4. We think gains may be more modest as we advance, but the fundamental foundation suggests that last week's pullback is not the beginning of a bear market.
- Perception: Rates have risen too far too fast, and are headed higher.
Reality: This served as the backbone of the market volatility last week, as investors fretted that higher rates will kill the music at the bull-market party. We agree that rates are headed higher, and we also agree that the Fed will likely be the one that turns the lights off. But we disagree with the path and the timing that seem to be embedded in the market's reaction last week. We think rates are on a gradual trek higher, not a steep, uninterrupted one. And rates have indeed risen, with 10-year yields reaching a seven-year high last week, but not to levels that are choking off growth. Looking back at the last five bull markets, when stocks peaked, the federal funds rate was at an average of 7.2% and 10-year rates averaged 7.3%5. We expect rates to peak at lower levels this time, but we think there is still sufficient room before they threaten a recession or equity market valuations. Interestingly, up until very recently, the prevailing concern in the market was a flattening yield curve – the result of Fed hikes on short-term rates along with the lack of rising longer-term rates.
Key takeaway: Concerns over rising rates aren't going away, but we don't think the Fed policy is in imminent danger of killing the expansion. In fact, last week's CPI report showed that inflation remains modest. This should provide the Fed the flexibility to maintain a gradual approach to rate hikes. Prepare for additional market swings and for gradually rising rates with an appropriate fixed-income allocation and a diversified bond portfolio.
- Perception: The Dow fell 800 points in one day. This level of volatility is unusual and worrisome.
Reality: We'd replace "unusual and worrisome" with "normal." Part of what made last week feel unsettling to some was the fact that volatility has been almost nonexistent lately. Prior to Wednesday, the stock market hadn't had a 1% daily move in 76 trading days. What's more, there were only eight 1% daily moves for all of 20176. This level of tranquility makes normal levels of volatility seem more punitive and abnormal than they really are. The "VIX" index (a measure of volatility) spiked to 25 last week, after averaging less than 13 since July. The 20-year average for the index, however, is 20, and since 2012 we have seen only 10 instances when it surged to the levels of last week. In other words, this volatility is more of the norm than the exception.
Key takeaway: Expect more volatility. Our list of potential risks has grown, as trade/tariff uncertainties, elections, global growth headwinds, and Fed tightening are well-known challenges, but they did not emerge or accelerate in the last few days. Moreover, bull markets tend to end when the risks are ignored and only good news is reflected in stock prices. Even with fundamentals offering ongoing support, this pullback could have a bit more gas as the market fixates on risks and ignores the positives. Volatility is likely to persist as we progress in this cycle, but, fortunately, we think this sell-off will prove temporary. Look for opportunities to enhance the balance of your clients' portfolios. While the focus was on the decline in U.S. stocks last week, international equities performed better and bonds posted gains, demonstrating the value of proper diversification.
Sources: 1. Bloomberg, 2. Ned Davis Research, 3. Factset, 4. Morningstar Direct, Bloomberg, 5. Factset, 6. Bloomberg
Craig Fehr, CFA
The Stock & Bond Market
|Dow Jones Industrial Average
|S&P 500 Index
|10-yr Treasury Yield
Source: Bloomberg, 10/12/18. *5-day performance ending Thursday. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results.
The Week Ahead
The focus will be on corporate fundamentals next week as more U.S. companies report third-quarter earnings. Next week's important economic data includes retail sales on Monday, industrial production on Tuesday, and existing home sales on Friday.
Review last week's weekly market update.