Stocks’ Sudden Swoon Raises Questions

February 05, 2018

If you were wondering whether the market of 2018 was going to be anything like the market of 2017, this week you received your answer loud and clear. The low-volatility financial market environment that characterized last year has been violently replaced by a high-volatility, tumultuous backdrop so far this year.

On Monday, the S&P 500 crumbled by 4.1%, its steepest one-day decline since August 2011. The move put the venerable index 7.8% below its all-time high that was struck just a week and a half ago, and 0.8% into the red on a year-to-date basis.

At the same time, the Cboe Volatility Index (VIX) spiked 115.6% to last trade at 37.32. According to Cboe, that’s the largest percentage gain for the index in its history.

Monday’s stock market move marked an emphatic end to the S&P 500’s record streak of trading-days without a 5% correction (404 days). Now investors are wondering what has happened to cause such a sudden and dramatic shift in the market’s direction.

Catalysts

Every stock market sell-off has an explanation that is widely accepted by the investment community. For this latest decline, the most popular belief is that rising interest rates are hurting stocks.

The U.S. 10-year Treasury yield jumped to as much as 2.88%, a four-year high, following last Friday’s strong jobs report. That report also showed that wages grew at their fastest pace since 2009, which fueled worries that the Federal Reserve may have to hike interest rates not two or three times, as previously believed, but as many as four times to prevent the economy from overheating and inflation from getting out of control.

Those rising interest rate fears carried over into this week, kicking off Monday’s stock market plunge. But what started as an orderly retreat snowballed into something more severe for another reason―the market had simply run up too far and too fast.

Investors were sitting on huge profits and traders were using record amounts of margin debt to finance speculative positions. When the tide turned, everyone tried to exit the door at once, resulting in the market’s outsized decline.

Big Drops Happen

While uncommon, large moves like those seen in the stock market on Monday are to be expected from time to time. In June 2016, the S&P 500 fell by 3.6% in the aftermath of the ‘Brexit’ vote in the U.K.

In August 2015 and during January and February 2016, the S&P 500 had multiple days with swings of 2- 5% as the market swooned on China-related fears.

Perhaps this market sell-off feels worse than it is because there hasn’t been volatility in the market for so long. With 2017 being so serene, the sudden shift to a high-volatility paradigm in 2018 makes the decline seem more dramatic than the raw numbers suggest.

Fundamentals Still Solid

After every market drop, the most common questions are always the same: will the sell-off continue, and what should investors do?

The answer to the first question is easy―nobody knows. On a day-to-day basis, the market is impossible to predict. A 10% correction is certainly possible; it would only take a decline of another 2.4% to get there.

That said, it seems unlikely that the latest pullback is the start of a much larger decline or a bear market.

The fundamentals of the economy and corporate America are outstanding. GDP has a good shot to grow at 3% or more in 2018 for the first time in 13 years, while earnings for firms in the S&P 500 may grow by 16% or more, the fastest pace in eight years.

That’s not the stuff bear markets are made of.

Sure, inflation and interest rates may climb more than many were expecting at the start of the year, but how far and how fast they go up remains to be seen. For years, people have been predicting a surge in rates and inflation that never materialized.

Moreover, even if they do rise, it’s unlikely they’ll move enough in the near term to significantly alter the strong fundamentals of the economy and stock market. After all, the U.S. 10-year Treasury yield was last trading at 2.7%, still exceptionally low historically, and the personal consumption expenditure inflation gauge was growing at 1.5%, well below the Fed’s 2% target.

Buying Opportunity?

For most investors, the best course of action is to simply ignore the noise and stay the course. A bout of high volatility doesn’t alter the fundamentals, and so should not alter your investment strategy.

If anything, lower prices may be an opportunity to deploy new money into broad market funds like the iShares S&P Core S&P 500 ETF (IVV) or the Vanguard Small-Cap ETF (VB).

More aggressive investors may wish to target certain sectors or themes that they expect to rebound the most when the market eventually turns around.

Follow Sumit Roy on Twitter @sumitroy2

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