Sixteen months ago, we wrote a piece suggesting that fear-based decision making is usually a bad idea. At the time, many were concerned that the uncertain political environment (mainly Brexit and the possibility of Donald Trump being elected) was going to lead to a drop in the market. The incredible market returns since that period show that those fears were unfounded, and that sticking with a well thought-out allocation paid off well.
And here we are again. The Dow dropped almost 666 points on Friday, February 2, capping off a week in which it fell 4.1%. As if that wasn’t bad enough, it dropped another 4.6%, or 1,175 points, on Monday. Further, the yield on 10-year Treasuries increased to 2.85% (in other words, the price of bonds fell). This simultaneous decline in both stock and bond prices has created a kind of financial PTSD effect in some investors, who fear that another crash is on the way.
First, Some Background
So let’s get some context for this drop. Gross domestic product, or GDP, in the U.S. increased by 2.6% in the fourth quarter (not stellar, but healthy). Many large companies have reported solid earnings. Following the tax act, business owners are announcing wage increases, greater investment and increased hiring. Boosted by those earnings reports, the Dow and the S&P 500 as recently as January 29 were continuing to set all-time highs, with the S&P 500 gaining 7.5% for the first 29 days in January.
This growth in earnings and the markets has been global. Market gains in Asia exceeded those in the United States through January 29, and those in Germany and France were strong for that period as well. A weaker U.S. dollar has supported significant economic gains in emerging markets. Indeed, emerging markets equity was the best performing asset class in 2017.
This dollar weakness was a big reason for the growth in U.S. stock values as well. In mid-January, the dollar hit its lowest level in three years, as compared against a basket of global currencies. This decline is welcome news to the large U.S. companies that export goods and services overseas, as it makes their products more competitive globally.
So why the market selloff? The short version is that investors are afraid that the strong corporate earnings and global growth will lead to inflation (which we haven’t seen in about a decade). On Friday, we received the January jobs report, which was better than anticipated and showed wages growing at their highest year-over-year rate since the Great Recession. Instead of welcoming this news, markets feared that these wage and employment gains could translate into wage inflation.
Greater inflation could lead the Fed to increase short term interest rates more rapidly than they currently plan to. If the Fed raises short term rates more quickly, it could cause banks to raise the rate they charge for loans, making it harder and more expensive for companies to fuel further growth with debt. This combination of higher interest rates and inflation could create a drag on the economy, bringing down stock prices and bond values.
This fear is made worse by several other factors. Americans’ savings rate dropped to 2.4% in December (it had been as high as 6.6% right after the Great Recession) as they started to feel wealthy again. Consumer spending, in turn, is outpacing income growth: spending rose at 3.8% in the fourth quarter, its highest rate in three years (a big factor in the drop in savings rates). Retail investors, many opening brokerage accounts for the first time, are finally starting to buy stocks after a nine-year bull market. It’s often a sign that a bull market is almost over when retail investors start to jump in. If the market turns on these investors, and they in turn slow their spending because they no longer feel rich, the economy could slow with it.
And while the drop in value of the dollar has helped large U.S. exporters, continued weakness might cause investors to lose faith in the U.S. economy generally. Dollar weakness also drives up the cost of imported goods, which hits U.S. consumers.
So this potential combination of higher interest rates, greater inflation, lower consumer spending and less savings cushion could all combine to weaken the economy. Taken together, these fears start to explain the dramatic recent drop in securities prices.
No Reason for Worry
Yet in spite of these challenges, now is not the time to sell. In fact, these market movements are fine, because they’re normal.
Market prices often move on fear of future events, not just on facts themselves. The facts as we know them are as follows:
Taken together, these facts paint a picture of a global economy that is robust, rather than one that is based on speculation (as was the case in 1999 and 2007).
Next, let’s talk percentages. Even though Monday’s drop was the largest point drop in Dow Jones history, it didn’t even break the Top 20 in terms of percentage drop in the value of the index. It was eye-catching, but not all that significant historically.
Further, this fall was long overdue. Research shows that market corrections (a drop in value of 10% or more) happen about once every two years on average. The S&P 500, which didn’t even have a 5% pullback all last year, has never had back-to-back years with corrections of less than 6%. Such corrections, though unpredictable, are normal, and historically don’t last long.
Finally, and most critically, stock market moves like this only matter to short term investors (who shouldn’t be invested largely in stocks anyway). If you invested $10,000 in the S&P 500 in October 2007 (at the height of the market and just before the crash) and held it until the end of January 2018, your investment would have generated a 131% cumulative total return, increasing to $23,101. You would have doubled your money even after losing half of it in the first six months.
Diversification, as always, is critical to avoiding the hurt from a big drop in a single market segment. Diversify globally in case the dollar stays weak and other countries perform better than the U.S. Diversify by size, in case this environment favors smaller companies rather than larger ones. Diversify with a slight tilt toward lower priced “value” stocks, in case higher interest rates and inflation brings an end to the decade-long dominance of growth stocks.
And stay disciplined by focusing on your time horizon, which is the most important piece of your investment strategy. You may remember the bursting of the Dot-Com Bubble or the Great Recession, but your portfolio doesn’t. Not if it stayed fully invested, anyway.
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