## [# Swedroe: Drivers Behind The Dip](/sections/index-investor-corner/swedroe-drivers-behind-dip)
# Swedroe: Drivers Behind The Dip
A look at the many factors that could have contributed to the recent market dip and why they don’t really matter.
[](/contributors/larry-swedroe)
[By Larry Swedroe](/contributors/larry-swedroe)
Feb 12, 2018
Edited by: Larry Swedroe
Share Email LinkedIn Facebook X (Twitter)
googletag.cmd.push(function() {
googletag.display('js-dfp-tag-article_page_302x26');
});
Loading
The U.S. equity market had a very strong year in 2017, with the S&P 500 returning 21.8%. And 2018 got off to a strong start, with the S&P returning 5.7% in January. In addition, volatility, as measured by the VIX, was at historically low levels, ending 2017 at about 10.
While volatility began to pick up a bit (we ended January with the VIX at about 13), it remained at historically low levels. Then, on Feb. 1, although the S&P 500 fell just two points, the VIX jumped to over 17. The following day, the S&P 500 fell 60 points (2.1%) and the VIX experienced its largest one-day increase, jumping all the way to 37.
It has remained at relatively high levels since (between about 28 and 33). What’s more, the S&P 500 gave up more than all of its year-to-date gains, closing Feb. 8, down 3.5% for the year. These kinds of major negative moves can cause even investors with well-thought-out, written and signed investment plans to lose discipline and engage in panicked selling.
Given the lack of any major negative economic news, investors and the financial media alike struggled to explain the market’s behavior. You have likely read all kinds of hypotheses, including some blaming risk-parity strategies, inverse leveraged VIX funds and managed volatility strategies, among others. Unfortunately, the research shows that often there is no good economic explanation.
The best example of this is the crash of October 1987, when the S&P 500 fell about 22% in one day. We have had several “flash crashes” as well. With that in mind, I thought it would be helpful to review the determinants of stock prices and provide some possible, if not likely, explanations for this most recent crash.
**Earnings & Discount Rate**
Stock prices are determined by two things: earnings and the discount rate (the rate on the riskless benchmark of one-month Treasuries plus the risk premium demanded by investors) applied to those earnings. Earnings are the numerator in the discounted cash flow calculation. The discount rate is the denominator.
Fortunately, the news on the economic front is just about as good as it gets. In fact, for the first time since before the financial crises, almost all developed and emerging market countries have improving economies, with growth, and estimates of future growth, increasing.
Additionally, news on the inflation front has been quite benign. Finally, with recent tax cuts and rising expectations for U.S. economic growth, corporate earnings reports have been strong, with most reports coming in higher than estimates. The [latest estimate of operating earnings for the S&P 500](https://www.yardeni.com/pub/peacockfeval.pdf) in 2018 is about $155, up from about $132 in 2017, an increase of 15%. Surprisingly, at least to most forecasters, the weaker dollar is increasing earnings of U.S. multinationals.
Thus, there doesn’t appear to be anything in the economic data to explain why the markets would crash as they have. We will turn to the discount rate and see if it is the culprit.
Many investors are concerned that the market is vulnerable because valuations are excessively high (the Shiller CAPE 10 was still above 30). That’s another way of saying the discount rate is too low. With the S&P 500 closing Friday at 2,620, earnings of $155 translates into a price-to-earnings (P/E) ratio of 16.9, not much above the historical average. (For those concerned about valuations being high, I recommend you read my [recent article on the subject](https://www.etf.com/sections/index-investor-corner/swedroe-seeing-valuations-clearly).)
**Investors Demand Larger Risk Premiums**
Stock prices can fall even when earnings are rising if the discount rate increases enough. There are several issues that could explain why investors have begun demanding a larger risk premium. The recently passed tax cuts were not offset by increased revenue, creating fears related to massive budget deficits in the face of a record-high domestic debt-to-GNP ratio.
While it is possible that faster economic growth could pay for the cuts, investor concerns about this could have led to a rising risk premium. Then, on Feb. 9, Congress passed a spending bill that avoided a government shutdown. It included large increases in defense and nondefense expenditures, exacerbating the budget deficit problem.
Investors were already concerned about the impact the stronger economy would have on interest rates—the Federal Reserve was already expected to raise rates three times in 2018. Given the concern about the impact of rising interest rates on stock prices (stocks compete with bonds), the large jump in the budget deficit coming at a time of stronger economic growth could lead investors to raise the discount rate.
Adding to these concerns is that the Fed will continue its policy of unwinding the trillions of dollars of asset purchases it made during its quantitative easing program. The increased supply of bonds coming at a time of increased demand for borrowing (from the stronger economy and rising budget deficits) provides another explanation for a rising discount rate.
There are some other issues that could lead investors to increase the required discount rate. With the strong economy, and with unemployment at just 4.1%, some are concerned that we could see inflationary pressures from rising wage demands. That could also lead the Fed to raise rates more than the expected three times.
There is also some concern that President Trump’s trade policy could set off a trade war, which is about as sure a way as there is to create a bear market. Balancing this is that the stronger economy reduces equities’ risk, which could lead to a declining equity risk premium (which could offset, or more than offset, a rise in the rate on one-month Treasury bills).
**Strategies That Worsened The Dip?**
Having covered these issues, there are some other factors that could have led to the market’s dip. First, some have speculated that risk-parity and managed-volatility strategies have been major contributors to the decline. Most investors think that if their asset allocation is constant, so is their risk (unless other actions are taken).
However, the risk of a portfolio is actually time varying. When equity risks are rising, the risk of the portfolio is rising as well unless you lower your equity allocation, or lower exposure to other risky assets. Thus, risk-parity strategies may be forced to sell equity positions when risks rise (just as they increase their positions when risks fall). With equity risk rising (as measured by the VIX), managers might have to sell equities to keep their portfolio risk at the same expected level.
Managed-volatility strategies are based on research that shows current volatility is predictive of future volatility. Thus, if a portfolio manager is targeting, say, 10% volatility for the portfolio, when volatility increases, the manager must lower their exposures (reducing the risk of leverage). And when volatility decreases, they must raise their exposures. The sharp rise in volatility may have led to some funds having to reduce their equity exposure. (For those interested, I recommend reading what [Cliff Asness of AQR has to say](https://www.aqr.com/cliffs-perspective) on the issue of risk parity and managed volatility strategies being responsible for the crash.)
You could add momentum strategies to this list of suspects. The stock market had been on a strong run, causing momentum funds to be long equities. If the market continues to drop, momentum funds will eventually reverse their positions and sell equities—driving the market lower.
Another possible cause of the sharp drop in equity prices could be margin calls. At the end of November 2017, [margin debt stood at a record $580 billion](https://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=table&key=3153&category=8), more than double the level it was just six years ago. Falling equity prices can lead to a vicious circle as margin calls have to be met, investors sell stocks to meet the margin call, prices fall further and more margin calls are made.
**Problem Of Easy Monetary Policy**
I also believe there is another possible explanation, one likely to play a more important role in the future. The Fed’s extremely easy monetary policy since the financial crisis led to what has now been a decade of very low interest rates on high-quality bonds.
This led many, especially those who rely on a cash-flow approach to investing (relying solely on interest income, dividends and fund distributions to meet their spending needs), to shift assets from safe bonds to riskier assets, such as preferred stocks, stocks paying high dividends, REITs, lower-rated corporate bonds and MLPs.
Those investors allowed their need to take risk to dominate the asset allocation decision, ignoring their ability and willingness to take risk. Thus, the addition of riskier assets may have pushed the portfolio’s overall risk to an unacceptable level. That works fine as long as the risk doesn’t show up. With interest rates on safe bonds rising, and stock prices falling, we could see many of these investors reverse their decisions, selling riskier assets and once again limiting their fixed-income holdings to only safe bonds.
Each of the preceding suspects may have played at least some role in the sharp drop we experienced in early February. Compounding the problem is that, when volatility spikes, liquidity tends to dry up. The result is that even relatively small amounts of selling can lead to sharp declines in prices. The lack of liquidity may help explain the dramatic intraday swings we have been seeing.
**Markets Provide Discipline Tests**
The academic research shows that the most important determinant of the return of a portfolio is its exposure to asset classes and factors. However, it’s my experience that the most important determinant of the returns investors actually earn is their ability to adhere to their well-thought-out plan.
The reason is that dramatic falls in prices lead to panicked selling as investors eventually reach their “GMO” point. The stomach screams, “Don’t just sit there. Do something. Get me out!”
Investors have demonstrated the unfortunate tendency to sell well after market declines have already occurred and buy well after rallies have long begun.
That is why it is so important to understand that investing is always so much about uncertainty and never choosing an asset allocation exceeding your risk tolerance. Avoiding that mistake provides investors the greatest chance of letting their heads, not their stomachs, make investment decisions. Stomachs rarely make good decisions.
**Summary**
The good news is that if we limit the discussion to the economy and its impact on equity risks, there doesn’t seem to be any major reason for concern. That doesn’t mean that stocks cannot crash. They could do so because of unexpected events occurring (the appearance of so-called Black Swans), or for the reasons we have been discussing. Unfortunately, my crystal ball is, as always, cloudy.
The important message I hope you will take away is that your investment plan should incorporate the virtual certainty you will experience severe bear markets, on average, about once a decade or so, and that you will have to live through many other “corrections” along the way. Each will test your discipline.
That is why it is so critical to ensure your investment policy does not allow you to assume more risk than you have the ability, willingness or need to take. It’s also a reason to use a total return approach, not a cash-flow approach, to investing; otherwise, low yields on safe investments may cause you to take more risk than you should.
Finally, if you are thinking about selling based on the recent crash, ask yourself whether Warren Buffett is more likely to be buying or selling. And you can also be sure he isn’t listening to the forecasts of some guru who believes that he or she has that clear crystal ball.
*Larry Swedroe is the director of research for* [*The BAM Alliance*](https://thebamalliance.com/)*, a community of more than 140 independent registered investment advisors throughout the country.*
[ Larry Swedroe ](/contributors/larry-swedroe)
Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he… [View Bio](/contributors/larry-swedroe)
Related Topics [Volatility](http://www.etf.com/topics/volatility)
[Equity](http://www.etf.com/topics/equity)