Client Correspondence on Market VolatilitySubmitted by RDM Capital on February 6th, 2018
The market correction of ~ 10% that began on Friday and has continued into this week was long overdue and foreshadowed in our most recent quarterly market commentaries. Despite the startling headlines from around-the-clock market coverage, we do not feel that the current correction is an indication that we are entering a bear market for an extended period of time or that the economy is suffering. In fact, the economy is beginning to pick up steam and, aided by corporate tax cuts, corporate earnings are expected to benefit in 2018.
But, if the economy is strong and growing, why has the market pulled back so violently in the past few trading sessions? There are three factors that at least partially explain the recent market moves: fear of rising interest rates, the impact of computerized trading, and complacency due to the recent bull market run.
First, there is growing concern that interest rates may rise quickly in the coming months, leading to a market downturn and economic recession. While the markets have expected rates to rise, the recent rise in the 10-year Treasury yield accompanied by indicators of strong economic growth (i.e. higher wages and inflation) have caused many to fear that the economy may be growing too fast. If the Fed is forced to rapidly raise rates to cool the economy and subdue inflation, this could stifle the economic expansion and lower stock valuations. In other words, good news for the economy is actually bad news for the market.
Second, automated, algorithm-based trading can cause large swings in the market over a short time period. It appears that many large funds had piled into a bet on low volatility and were forced to quickly unwind that trade when volatility rose due to concerns about higher interest rates. As technical thresholds are breached, computerized trading models can submit large sell orders, further exacerbating the decline. This is partially to explain why the Dow moved about 1000 points in an hour on Monday without any market news.
Finally, the sheer numeric amount of the decline is shocking to the system. Whereas as recently as a few years ago a 5% decline would have meant a 500 point drop in the Dow, the same decline today is over 1000 points. The consistent low volatility in the markets has led many to become complacent and a subsequent correction from such a high perch is therefore even more alarming than in the past.
In short, a recent rise in interest rates led to an increase in volatility, which combined with computerized trading and a natural human tendency to sell when the market is losing value, caused a sudden large drop.
While we aren’t concerned about short-term market movements due to computerized trading and panic selling, we take seriously the long-term impact of higher interest rates, as several bull markets have been halted by the economy over-heating and the Fed needing to step in with rapid rate hikes. However, we believe fears that rates are rising too quickly are premature. We still are at historically low interest rate levels. We expect rates to rise from these levels due to continued economic strength and higher inflation, but as long as corporate earnings continue to grow, higher interest rates do not mean we are headed to economic collapse. Further, the Fed has consistently taken a measured approach to raising interest rates, and we do not believe this will change despite the new leadership.
Rather than the beginning of a market collapse, we feel that this is a classic bull market correction that occurs periodically when the market has become temporarily over-valued. In this case, the market became too euphoric over signs of economic growth, tax cuts, and rising corporate earnings. While every year of a bull market typically sees two to three 5% pullbacks, the market had not seen one such correction since the presidential election. Therefore, a strong correction was long overdue and healthy for the markets to bring valuations back to more reasonable levels.
During times of market volatility, it is important for long-term investors to keep the market moves in perspective. The market is roughly flat for 2018 and up approximately 20% since the beginning of 2017, and economic and market fundamentals are supportive of gains once conditions stabilize. The market move on Monday, while unsettling, barely registers in the top 100 market declines of all-time on a percentage basis. Indeed, the Dow dropped 3.4% on June 24, 2016, after the Brexit vote, but market sellers on that day likely have regretted it. While we cannot guarantee that the market is at a bottom for the year, we believe a long awaited buying opportunity is beginning to present itself.
Finally, the recent market movements demonstrate the importance we place on financial planning in constructing investment portfolios. In anticipation of this correction, we have maintained healthy cash balances in client accounts for clients who have short-term income needs. For clients with long-term investment horizons, we intend to selectively invest cash as market conditions present opportunities. Nevertheless, we are always available to discuss with you the impact of the recent market swings on your risk tolerance and investment goals. Please contact us if you would like to discuss your individual investment account.
Thank you for your continued trust and confidence in us.