The winds of change blew through the financial markets in February, leading to the first stock-market correction (a decline of at least 10% from the previous high) in two years. What caused the correction, and what — if anything — do these developments mean? Here’s some perspective on what we’ve seen so far in 2018.
- High Valuations
The stock market had been so strong for so long that some sort of drop was overdue. More importantly, stock valuations are still so high that everything needs to unfold perfectly for those valuations to be justified. That “Goldilocks” picture was temporarily disturbed by inflation concerns and the market plunged in response.
- Inflation Concerns
The jobs report released in early February showed wage growth had increased faster than expected, sending bond yields higher and stock prices lower. It’s been a long time since good news for the economy has been interpreted as bad news for the financial markets, but that’s what happened here. It could be a harbinger of things to come, if faster economic growth threatens to accelerate the pace of interest-rate increases.
- Rising Interest Rates
Inflation is the bane of fixed-income investments, because it forces bond yields higher and prices lower. Interest rates already had been rising in 2018 before the inflation surprise. Given that some believed inflation was permanently buried as an investment concern (due to demographics, automation trends, etc.), its sudden reappearance forced investors to rethink if current valuations were appropriate. For about two weeks, that answer was “apparently not.”
- Portfolio Hedging and Betting Against Volatility
In recent years, some investors made money betting that the lack of market volatility would continue. The sudden unwinding of these risky positions contributed to the speed and severity of the recent correction. And while the retail investor side of this trade largely blew up, some believe the institutional side of this trade is still intact. Which means it continues to represent a future risk.
The four factors described above remain in play. None was resolved, even if the immediate fears they produced have receded. To those factors, there’s another that promises to grow in prominence in coming months:
- Central Bank “Quantitative Tightening”
Since 2009, the central banks of the world have engaged in “Quantitative Easing,” which can be loosely thought of as using government money to boost the prices of stocks, bonds, and other financial assets. Now, the U.S. Federal Reserve has set an explicit schedule to sell the assets acquired under its QE program, and other central banks are expected to follow suit. The net effect will be to turn Quantitative Easing into Quantitative Tightening. This monetary policy experiment has never been tried before, so no one really knows what to expect. But QE clearly pushed asset prices higher, so it’s not crazy to suspect QT might have the opposite effect.
While the recent correction doesn’t tell us much about the likelihood of the next bear market, it does remind us of one absolute truth of investing: the market always cycles between bull markets and bear markets. If you’re going to be an investor over a span of decades, you’re going to have to weather a number of bear markets.
Our counsel on how to do that is simple: continue to rely on the discipline imposed by a structured, proven approach to risk management. This will save you from your emotions and counterproductive buying/selling.
Such an approach means following a personalized long-term plan, which balances your need for growth with your fear of loss. If your plan is set correctly, then bear markets can be weathered financially and emotionally. If you need help establishing — or sticking with — an appropriate investing plan, see the Private Client announcement this month.
If the recent correction has you fretting over the risks of an upcoming bear market, consider reducing your stock holdings. SMI’s Dynamic Asset Allocation and Fund Upgrading strategies have some risk protection built into them, but that’s no substitute for an appropriate blending of riskier and conservative holdings in your portfolio.
When market storms come — and they will — it’s important that you trust your pre-determined plan, rather than being blown about by the emotion of the moment.
(Much of this information was provided to SMI members online as events unfolded. If real-time updates like these would be helpful to you, be sure to visit the SMI website during periods of future market volatility.)