Economic and Market Review
The Dow Jones Industrial Average (Dow) closed on Monday February 5th with a 1,175 point loss. One of the major headlines of the past week has been the stock market experiencing volatility and losses since hitting a peak on January 26th. As of the close of business on Monday February 5th, the market (I’ll refer to the Dow in this letter as the “market”) is now slightly negative for 2018.
Many investors are naturally wondering “How long will this last?” or “How bad will this be?” In the remainder of this letter, I’ll give you my perspective by presenting some historical data followed by my comments.
Consider the market since the beginning of 2016:
- The Dow declined 10% from January 4th through February 11th in 2016. This was one of the worst starts to any calendar year in the history of the market. In the midst of the decline, some of the explanations were:
- The health of the world economy was in question.
- The Federal Reserve (Fed) had just increased the federal funds interest rate by .25% in December 2015 – the first fed funds rate increase from the Fed in over a decade – and during the December meeting the Fed anticipated four additional rate increases for 2016 (Reminder: by the end of 2016, the Fed increased the federal funds rate one time – in December 2016 by .25%).
- Oil fell to nearly $26 per barrel in February 2016. The extremely low oil prices were expected by some analysts to decrease further, and low oil prices were perceived as an indication that the worlds’ collective economies could be headed for a downturn.
- The stock market was volatile in June when the Brexit vote surprised the world. The Dow dropped 3% on Friday June 24th. By July 8th – two weeks after the Brexit vote – the Dow was higher than the Dow on the day prior to the Brexit vote.
- The stock market had extreme volatility for 24 hours after Election Day, November 8th. Technically, around midnight on the night of the elections, the Dow futures were down 900 points. In other words, it was anticipated the Dow would open on November 9th 5% below the November 8th closing price; however, on November 9th the Dow gained 1.5% for the day.
- By year end the Dow had a 12% return for 2016.
- There are approximately 250 business days in a typical year. In 2017, the Dow had a greater than 1% change in value only four times:
- March 21st (-1.38%)
- May 17th (-1.15%)
- August 17th (-1.06%)
- November 30th (up 1.08%)
- By year end the Dow had a 24% return for 2017.
- The Dow Jones Industrial Average (Dow) gained 7% from January 2nd through January 26th in 2018. This was one of the best returns for the month of January in three decades. In the midst of the increase, some of the explanations have been:
- Earnings have been mostly positive, and the economy has demonstrated it is not regressing.
- The Federal Reserve (Fed) increased the federal funds rate five times since December 2015 (.25% increase each time) yet the market increased. Perhaps investors have become comfortable with the gradual rate increases, which were telegraphed weeks in advance.
- Oil increased in price over the past two years, showing some evidence that the worlds’ economies have stabilized.
- At the close of business on Monday February 5th the Dow had a -2% return for 2018.
Why did the market sell off recently?
The correct answer is: there is no single reason why. However, here are some reasonable explanations.
- Inflation might increase faster than the Fed’s 2% annual inflation target.
- The Fed might increase rates faster than originally expected.
- Bonds have declined in value and thus increased bond yields. Those yields might be more appealing to investors than owning stocks which could be overpriced.
- Perhaps the U.S. labor force participation rate has peaked, and if so, the supply of workers could remain static (thus leading to wage inflation if employers have to compete to attract employees by offering higher wages).
- The U.S. dollar has fallen to a 4 year low, and the weaker dollar might increase the rate of inflation as U.S. goods appear to other countries to be relatively less expensive than when the U.S. has a strong dollar. If we sell more U.S. products, companies could raise their prices because of greater demand.
Simply put, some investors likely sold stocks just “because”; because the market started to drop, because the market has been so positive for so long, and/or because confusion and uncertainty have crept in.
Additional points to consider
- The economy moves gradually, and is assessed over long periods of time. We have had an extremely slow growth economy (compared to historical standards) over the past decade.
- The stock market can move quickly – as evidenced by the past week, and multiple other times over the past several years. Wedged in between the volatility was a long stretch throughout 2017 of a complete absence of volatility. Volatility is normal but has been absent for a long stretch of time.
- After 2008-2009, central banks all over the world had to assess how to “re-inflate” their local economies. The basic thrust from most countries was to increase money supply, increase liquidity, purchase bonds from banks and maintain low interest rates. All of these efforts were purposely to inflate the economy that had just deflated. It is not altogether different than re-inflating a balloon or a ball that has lost air pressure – in the case of financial markets, money is used to re-inflate the economy. The key point is this: since 2009, we set out to purposely create inflation, and now there is evidence we are on the verge of succeeding in doing so. The markets are pausing to reflect on how much inflation we might have.
It seems fear replaced greed in the market over the past week, and a fair question is whether or not that phenomenon will last. Remember that 2016 began with an expectation that the world economy would suffer, and it took some time for the confusing data points to show evidence that the world economy was healthy. Since 2016, we have had months of continuous confirmation that the economy is healthy, but now, when it seems we have succeeded in our goal of inflating our economy, the market is wondering “What’s next?”
I believe the positive trend of the economy will continue for some time, and it seems reasonable that we will have an increase in the rate of inflation. Given time, there should be less confusion and less uncertainty about inflation – investors hate confusion and uncertainty, and that is a big part of the reason why markets are volatile right now.
I recommend holding your positions while waiting for volatility to subside. Patience has always been rewarded over time.
Thank you for your trust.
Timothy A. Weller, CFP®
CERTIFIED FINANCIAL PLANNER™