Volatility is never a fun experience. There's an old saying that bull markets go up like escalators and correct like elevators. However, that’s the necessary price of admission to achieving long term stock market gains. When younger investors look at the long term stock market averages that have beaten every other major asset class (e.g. cash, bonds, real estate, commodities, etc.) over 100+ years, they often ask “Why doesn’t everyone just invest everything in stocks?” The answer is volatility. Enough investors allow themselves to get “washed out” of the market during volatile times which sends prices down until the expected future returns of the market become attractive enough to draw a new wave of investors back in and the cycle begins anew.
- Staying calm and remaining rational about your long term investment goals is the single best thing you can do in a market pullback.
- The S&P 500 has given back January’s gains, but that’s about it.
- January’s pre-pullback growth was unsustainable. At one point last month stocks were on pace to go up 150% in 2018, 3x more than the best year ever.
- Although it’s always hard to pinpoint exactly what caused a sell-off, it would appear that the volatility of the last week has been caused by fears of too much economic growth, rather than too little. A strong jobs report last week gave the green light to the Federal Reserve to embark on a series of interest rate hikes to normalize monetary policy.
- Higher interest rates are generally bad for financial assets, at least in the short term.
- Markets are inherently volatile and this pullback is a stark reminder of that fact. The lack of volatility investors have become accustomed to in the last 18 months is the exception, not the rule.
- Corrections of 10% or more have occurred more often than not in the last 40 years, but even in years with corrections the markets finished positive the majority of the time.
It’s been a whirlwind week in the stock and bond markets. Following last week’s stock market declines, stocks fell further yesterday. While stabilizing so far today, this is the first real volatility we’ve seen in markets since the beginning of 2016, when fears over falling oil prices sent stocks into a correction. Then, like now, we didn’t think it was the beginning of a bear market for a variety of reasons.
The sell-off of the last few days is most likely due to strong employment and economic growth while previous sell-offs in this long-running bull market have been based on fears of too little growth.
Isn’t a growing economy and lower unemployment a good thing? It certainly is (especially if you were one of those recently-unemployed people). But the market and the economy are two different things and what is good for one is not always good for the other. A prime example of this is the most recent jobs report which showed 200,000 jobs being added to the economy and average hourly earnings for private-sector workers rising 2.9% from a year ago. It’s not the additional jobs that are spooking the markets; we’ve added well over 100,000 jobs a month on average for the last few years. It’s the pickup in wages that’s moving markets. So far in this decade-long recovery, the average Joe hasn’t had a meaningfully bigger take-home paycheck even though almost every other economic indicator has improved.
Again, why is the common man having a few more bucks in his pocket a bad thing for the stock market? Won’t they spend more money if they make more money? Probably. All else being equal, that would be good for the economy and markets. However, inflation (which has been hibernating for a few years between 0-2%) is historically driven by wage gains. Why? When you can’t find a qualified person to fill a job opening because everyone who wants to work already has a job, what choice are you left with? Offer more pay to lure potential employees. When everyone collectively does this, that’s typically when you see inflation start to kick up a notch.
If inflation starts creeping higher, that tells the Federal Reserve it’s time to raise interest rates to keep the economy (and asset prices) from overheating. The Fed didn’t raise rates quickly enough leading into the dot.com bubble and the housing crisis and fears making the same mistake a third time in a row. The Federal Reserve has kept interest rates extremely low since the Great Recession to stimulate economic growth and to push investors into riskier assets. We started calling this phenomenon the “musical chairs of markets” a few years ago. If you were a CD buyer before the financial crisis, you might have been forced to buy bonds in search of a higher return. If you were traditionally a bond buyer, you might have purchased Procter & Gamble and Philip Morris stock for the strong dividends which were higher than bond yields at the time. In short, low interest rates encourage risk taking, reward debtors and punish savers.
Why do low rates increase risk taking? If you’ve ever thought about buying a rental property, you would be more likely to buy it if you could borrow at 3% interest than at 10%. Obviously a lower interest rate is more attractive and may even increase the amount you’d be willing to pay for the property. This phenomenon happens in stocks, bonds, real estate, farmland, etc. Any income-producing asset is worth more if interest rates are low and progressively less as rates climb. If interest rates climb slowly and steadily, we think the markets can absorb the higher borrowing costs. If they rise much more quickly than previously anticipated (which seems to have been the sentiment from the past few days), there could be more volatility ahead.
Overall, we believe maintaining a balanced investment approach and not reacting too emotionally to swings in the market continues to be the best path forward for positive long term returns.
As always, we thank you for the privilege of serving as your fee-only registered investment advisory firm.