As the market correction was unfolding early last week, I provided some commentary about what was going on, and Matt dug into the ultimately more-important question of how we should respond to the downturn as individual investors. As usual, those posts generated some good questions/comments, and the back-and-forth between members (with us chiming in as well) was helpful to a lot of readers.
If you tend to get nervous during market swoons and you're not in the habit of checking those articles and the discussions they foster (in the article comments), I'd encourage you to start checking those out. Many members communicated to us following the 2008 Financial Crisis that those daily articles and discussions were an emotional lifeline that helped keep them from taking counterproductive actions when the market storms were at their worst.
With another week's perspective under our collective belt, I thought it might be helpful to go back and dig into some of the common questions concerning the recent downturn. I'll list what I think are the most important/common questions that I'm seeing and attempt to answer them here. If you have others, post them in the comments below and I'll try to address them there.
Was this a pullback, correction, or bear market?
To make sure we're all on the same page, terminology-wise, this was a stock market correction. Pullbacks are generally considered to be market declines of less than -10% from the recent high. The term correction is normally applied when the loss reaches -10% from the recent high, which is what we just experienced. A correction turns into a bear market when the loss reaches -20%, which is still a long way off at this point. Usually, the term bear market implies a decline that takes place over several months as well, but admittedly, the terms start getting blurry when that time aspect is added.
What caused this month's correction?
I'm going to break this into three parts, because there are really three key aspects to this. There's what laid the groundwork for the correction to take place, the immediate trigger or catalyst that sparked it, and the flammable underbrush that caused it to burn so hot, so fast.
First, the underlying groundwork. This is what I focused on last week in my Perspective post. The market has been so strong for so long, with virtually no downside moves over the past 14 months, that it was overdue for some downside action. Even more importantly, stock valuations have been stretched so high that it's fair to say the market is priced for perfection. Everything basically needs to go according to script for those valuations to be remotely justified. We've talked a lot about market valuations over the past couple of years, so I won't belabor this point — click the link above for more.
While high valuations coupled with a sense of complacency from the lack of recent volatility were the backdrop that made a correction likely, the immediate catalyst that set it off was inflation fears. This distinguishes this correction from the four others we've experienced in the decade since the Financial Crisis. In each of those four prior cases, the underlying concern was too little growth — that the economy was faltering and growth might stall out. In contrast, this correction was based on the opposite fear of too much growth — that the economy might be accelerating quickly enough that inflation could become a problem. This would force interest rates up faster than expected, which would have ripple effects for all types of investments, including both stocks and bonds, as well as for the economy in general. It's been over a decade since we've seen the "good news is bad news" reaction from the markets, but that's exactly what this was.
While inflation data had been pointing subtly higher in recent months, the tipping point came in the last jobs report, which showed more of an uptick in wage growth than was expected. The U.S. has had an incredibly low official unemployment rate for some time now, but that hasn't translated into higher wages, keeping inflation fears at bay. But if wages start moving higher, the inflation conversation takes on a whole different tone, given how low unemployment is. When that jobs report came in, bond yields spiked higher and the stock market started to wobble.
This may seem like an overreaction to what wasn't a terribly big deal in the report itself, but it needs to be understood in the context that for the past decade many investors had convinced themselves that inflation was largely buried permanently as an investment concern. Aging demographics, automation trends, and the inability of central banks to generate any inflation to speak of despite years of extraordinary efforts made many think inflation was dead. So from that starting point, to see inflation rather suddenly making a rebound and appearing back on the threat radar caused a significant rethinking of what that threat means, given current asset valuations. Put simply, that jobs report was the tipping point that caused investors, en masse, to rethink how they have been pricing risk in the market.
I should note that while the market has stabilized in recent days, this issue is by no means resolved. This morning's inflation data was again stronger than expected. The immediate reaction to that report was similar: yields spiked and stock market futures dropped sharply. This time, however, the market brushed off the news pretty quickly and stocks rebounded. Other inflation-sensitive assets are reacting as one would expect from higher inflation indications: bonds and real estate are down, while gold is up significantly. But importantly, if inflation continues to tick higher, there's likely to be more trouble ahead, because a re-emergence of inflation truly would cause everything to shift in terms of valuations, portfolio construction assumptions, and on and on.
Valuations set the table, inflation fears provided the spark, and much as in 2007-2008, a little-known corner of the market provided the dry tinder to turn a small spark into a decent sized fire.
Without going into a lot of detail, in recent years, some investors have made a lot of money betting that the lack of volatility in the market would continue. There are sophisticated ways that institutions do this, and there are more straightforward ways that individuals have done this via ETFs (and ETNs; exchange-traded notes). These bets involve a ton of risk, and over the past two weeks, many investors in these ETF/ETNs that were "short volatility" learned that they could make money in that trade for years, only to give it all back in a day. The two largest instruments used by individuals for this purpose lost -81% and -92% respectively last Monday (Feb. 5), causing the ETN version of this product to liquidate.
I don't want to get bogged down in the details of this, other than to point out that the massive unwinding of some of these positions certainly contributed to the speed and severity of the downturn. And while the retail investor side of this trade largely blew up over the past couple of weeks, there are some astute market observers who feel the institutional side of this trade is still intact. Which means it could blow up at some point down the road, especially if the participants take away from the past two weeks the idea that their version survived and is therefore "safe" to continue betting on. For those interested in this admittedly complicated subject, the end of this article has more on that.
With those causes of the correction out on the table, I'd be remiss if I didn't include this additional "cause," as pointed out by Ben Carlson:
Is it over?
This is the big question on everyone's mind. And the honest answer is nobody knows for sure.
From a technical standpoint, even though the market has stopped falling for now, there's no way to declare victory yet. The technical evidence won't support that idea until the market rises back above some of these recent rollover levels. At this point, the market has only made a series of lower highs and lower lows, which is classic downtrend material.
Now that certainly doesn't mean the market will continue lower from here. It just means it hasn't proven anything yet. This morning's response to the bad inflation data would seem to be a positive sign, given that the market wobbled briefly but then recovered quickly. But bond yields continue to tick higher, with the 10-year Treasury yield now approaching 2.90%. There are more than a few people out there anxiously waiting to see what the market does if that yield continues to surge through the psychologically-significant 3% level.
There's one follow-up point I want to make here to correct a perception I may have fostered with my post last week. Looking back, I wish I had explained one thing differently, because I think I may have given the idea that the risk of a severe bear market is low given the strength of the economy. The reality is that bear markets almost always begin before signs of economic deterioration are evident. The stock market always leads the economy. So it wouldn't be inconsistent at all that if this is the beginning of a bear market, that the economic picture would still look bright today. Given today's high market valuations and the potential that a "new" inflation narrative could start to sweep through the market, significantly altering investor perceptions of risk and what various asset class returns are likely to look like under the new paradigm, I definitely don't want to imply that the market is relatively "safe" here simply because the economy looks to be in good shape. That simply isn't the case.
That said, none of this means the recent correction was anything more significant than any other normal correction. The point is that it's impossible to know at this point. It could be something, it could be nothing. We may look back on it as the beginning of the next bear market, or it may be largely forgotten a month from now as the market resumes making new highs.
And that's precisely why we use mechanical triggers within our strategies to tell us what to do. That keeps us from overreacting to episodes like this. We intentionally tune the processes built into our SMI strategies so they don't respond to routine corrections, because making portfolio changes based on those types of short-term moves is counterproductive. But we know that the processes built into DAA, and now Upgrading, will respond if this correction starts to turn into the next bear market.
We purposely have set up the SMI strategies so you don't have to figure out whether we're in a correction or a bear market. Just keep following the strategies as they're laid out and the processes already built in to them will alert you if there's a need to take protective action.