Last Week’s Reminder: Volatility is a Fact of Life for Investors
Volatility spiked for stock markets around the world last week. Higher in the volatility in the U.S. meant that indices such as the S&P 500 US stock index fell as much as 11.8% from its peak of 2,872.87 on January 26, 2018. The last time stocks had a correction, a decline greater than 10% from a peak, was two years ago in February 2016.
With stocks climbing steadily higher over the last two years, it is easy to forget that stocks can also go down. A historical study that goes back to 1930 by Bank of America Merrill Lynch1 found that a 5%+ pullback happens about three-times a year, 10%+ corrections occur about once a year, and 15% downturns come every two years.
The Roller Coaster Ride is Not Over
The stock market is on a roller coaster ride. After a steady climb over the last two years, the roller coaster fell, correcting by more than 10% from its peak. Ups and downs may be more frequent in 2018 as the stock market figures out how to interpret developments.
Many of the reasons cited for why stock markets corrected last week were also the same ones used to explain its rise. The reasons include inflation or pricing power, Jerome Powell as the new Fed Chairman overseeing interest rates, a strong job market, tax cuts and fiscal spending.
Optimists view a strong job market as support for continued economic growth. Pessimists view a tight job market means that the Fed may be more aggressive in increasing interesting rates in order to stem the risk of the economy overheating.
Optimists see inflation as a sign of pricing power, the ability for businesses to raise prices, which is good for profits. Pessimists see inflation driving up interest rates, raising the cost to finance business and a threat to growth.
Optimists believe tax cuts will boost profits and would dub the increase in fiscal spending as stimulus spending. Pessimists see tax cuts as moves that increase the budget deficit and would label fiscal spending as deficit spending that would increase our national indebtedness. President Trump’s proposed budget for 2019 calls for more spending on infrastructure and other projects that would add $7 trillion to the federal deficit over the next 10 years. More borrowing means that the US Treasury will issue more bonds to finance its spending. The law of supply and demand says that more supply should lower the price of bonds, which translates into higher interest rates.
We Are Cautiously Optimistic
We continue to be cautiously optimistic about the current investment environment. We are optimistic because business and economic fundamentals are solid. Earnings are improving, businesses have good access to capital for growth, the job market is strong, and the tax cut should boost business profits and increase disposable income for families. Interest rates remain low, and we believe global central banks will continue to maintain their easy money policies until they believe inflationary pressures are apparent. Continue reading