Stock market volatility returned with a vengeance this week, and anytime we see a 5% drop for stocks in a matter of days, we understand it catches everyone’s attention.
The volatility is particularly noticeable with the Dow Jones Industrial Index in the 25,000 range, where a 5% drop is the result of a numerical drop of more than 1200 points in only two days. We, now more than ever, live in a world of large numbers.
Now, as an investor, you and I both know that 5% and 10% corrections happen all the time and are extremely normal for markets. We live in a world where stocks grind higher relatively steady and slowly… but when they give up ground, the slide backward happens very quickly. At the end of the day, it’s the speed the pullback that makes people nervous.
If we quietly dropped 5% in a systematic way over a 5-month period, no one would be nervous… frustrated maybe, but not nervous.
So, in the spirit of how quickly markets have reacted, the Capital Investment Advisors‘ Investment Committee wanted to do the same and quickly give you an update on where we think things stand:
1. Stocks are still positive on the year, albeit slightly. Historically, it’s very normal in a mid-term election year to see almost no gains until midterm elections are over; relief comes November 7. There is a clear historical bias where markets tend to do their best in the final months of the midterm election year.
2. The economy continues to hit on all cylinders, which quite frankly is the main catalyst for this correction. The economic strength we are seeing has prodded the Federal Reserve to systematically hike interest rates. It was only December 2015 when the Fed Funds Rate was still at zero. Since then, the Fed has not only pushed rates higher but also increased the pace of rate hikes in 2018. The bond market, which also has a say-so in interest rates, has moved longer-term rates higher alongside the Fed moves. The 10-year yield has climbed from 2.4% at the beginning of 2018 to about 3.15% at the close of business on December 11.
3. Good News, Bad News: To some extent, this stock selloff is due in part to a stronger economic backdrop. This has added fuel to the fire for interest rates going higher. In the grand scheme of things, interest rates are more accurately “returning to more normal historic levels”. A 3.15% 10-year treasury bond yield is much closer to the “normal range” (say 4-4.5%) than the long period of time that the 10-year yield floated in the 1.5-2% range. This process of normalization is a net positive from a macro perspective but will not be without a few bumps in the road along the way.
4. Tariff battles are still a concern – but a full-blown Global Trade War is off the table. When discussing trade, we look at this past year as four separate battles. The US vs. Canada, Mexico, the EU, and China. All four are important battles for the US, but the risk of a Global Trade War on four separate fronts could have been devastating. The recent announcement of USMCA (new NAFTA) solves two of these battles. The third battle, the US vs. the EU has quieted down significantly as both parties have agreed to “play ball”, so to speak, and are working toward an eventual zero-tariff environment. That leaves China. Our trade relationship with China has arguably gotten worse and may take years to solve. However, the positive impact of solving most of our trade disputes in such a timely manner should not be underestimated despite the risks stemming from the ongoing Chinese negotiations.
5. Is a trade war with China enough to derail a strong US economy? The short answer is: not yet. Earnings in the US have remained strong and that remains the main driver behind higher stock prices over the past few years. We are about to start the 3rd quarter earnings season here in the US and all indications point towards a very strong earnings season. Expectations are that profits grew nearly 20% year over year headed into the end of 2018. Until Chinese tariffs start to take a material bite out of profits, markets will likely respond positively to a strong earnings season.
There is no one issue that has caused this recent ripple in stocks. One can attribute blame for the recent volatility nearly equally on higher interest rates, tariffs with China, and the midterm election cycle. At some point, the US economy falls back into recession and stocks will take a material hit… but we still think we are a long way off from that. In the interim, these corrections will likely remain buyable pullbacks. These pullbacks are never fun. These are the exact events that make investors nervous, and what makes investing so difficult. But we take solace in having diversified portfolios that rely on a variety of high-quality asset classes for our clients. That gives us peace of mind during these times of temporary pain.
As always, please don’t hesitate to reach out with any questions. We are here to help.