No doubt some of you have been fielding client questions or considering ways to ‘remind’ clients about more normal market volatility that has resurfaced over the past week.
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 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 is 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 de jour? Interest rates. Investors have to be careful in what they wish for. Seeing signs of stronger economic and stock earnings growth, driven by better fundamental conditions, tax cuts, business activity and general speculative ‘animal spirits’, 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, although 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 risk assets, 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.