Return to Volatility and Normality

The US and Global stock markets declined significantly and rapidly over the past week. From its peak the prior week on January 26th, the S&P 500 Index (a broad measure of 500 US large companies) declined almost 7% through Thursday morning, February 8th.

Let’s put this in perspective and share our thoughts. What should you be focusing on?

While no one can perfectly anticipate when a market drop will occur (in advance, accurately and all the time), this decline was long overdue, given the nearly straight up gains over the past 2 years.

The market action was swift and seemingly unexpected, but that is normal at times. Global stock markets have been extremely calm and lacking in volatility for more than 18 months, with few big down days at all. That is not normal. Volatility, or market moves either down or up, are normal and should be expected, as we have repeatedly emphasized.

If you look at the 3 month S&P 500 chart below, as of February 8th AM, you will see that the recent decline takes the Index back to the level it was at near the end of December, 2017. While the markets had big gains in January, 2018, those are temporarily gone.

An even more illustrative chart is the 2 year S&P 500 chart, as of February 8th AM, below. This shows the significant rise over the past 24 months and puts the decline of the past week or two in even better perspective. Stock investments are still solidly positive over the longer term.

There will be many “experts” who will provide all kinds of reasons and explanations for what caused this sudden decline. Some will be considered “gurus” for calling a market top prior to last Friday. None of this really matters in the long run. What matters is your portfolio and how that impacts you and your family’s goals.

The fundamentals of what drives the stock market are still strong. The stock market is highly correlated to expected corporate earnings and reported corporate earnings. Nothing changed in the past week or two regarding earnings. If anything, corporate earnings reports have been very strong, with most major companies meeting or exceeding their earnings expectations.

The stock market and the economy can diverge at times. The stock market may have gotten a bit ahead of itself, as January’s gains for one month were 60-70% of the historical annual average return for the US stock market for an entire year.

It is unlikely that investors can successfully time the market. Further complicating the prospect of trying to time the market is the fact that a substantial portion of the total return of stocks over long periods comes from just a handful of days, which of course can’t be predicted in advance.

As you can see from this chart below, the impact of missing out on a few days is very significant. The chart shows the annualized compound return of the S&P 500 Index from 1990-2017. The bars represent the hypothetical growth of $1,000 over the period and shows what happened if you missed the single best day and a handful of the best days. Missing only a handful of days would have resulted in substantially lower returns than the total period had to offer.

Thus, the prudent strategy is to remain invested during periods of volatility, at the appropriate allocation of stocks for your personal situation. We have helped our clients manage that. If you are not a client, this is a discussion you should be having with us.

 

Things are changing in the financial world, which the financial markets are adjusting to. As the economy is strong, job growth is good. That puts pressure on employers to pay more, which causes inflation. The Federal Reserve wants 2% inflation, which has not existed for a decade. As the economy continues to do well, this leads to the Federal Reserve raising short-term interest rates. The Fed has raised rates and may increase them by 3-4 times more this year, at 0.25% increments.

As interest rates rise, and the Federal deficit continues to rapidly increase, this potentially causes competition for the stock market. However, the cause of increasing interest rates is the strong economy, which translates into good corporate earnings, which is generally good for global stock markets, over the long term.

Another factor which must be added into this mix is the huge increase in US oil production. On Wednesday, the US Energy Information Administration (EIA) reported that US oil production soared to 10.251 million barrels a day last week. That was an increase of 332,000 barrels from the prior week. The EIA now expects US output to average almost 10.6 million barrels a day in 2018 and 11.2 million barrels a day in 2019. Prior to 2017, US energy production had never been near 10 million barrels per day and 5 years ago was 6-7 million barrels per day. In May, 2017, it was around 9.3 million barrels per day.**

Though global demand for oil has pushed worldwide oil prices higher, the US production will mitigate US gas price increases and puts somewhat of a cap on global energy costs. This helps to reduce inflation and the cost of raw material prices.

With all these conflicting factors, this is why we invest for the long term and structure the portfolios we manage to be broadly diversified. Reacting to short term declines can be more harmful than helpful. By working together with us in advance, we hope that you may be better able to handle uncertainty and volatility.

 

This Week’s Takeway: Declines are normal and in the long-term, temporary. US and International stock markets have risen dramatically over the past years. With that perspective, the impact of the decline for a diversified portfolio from the past week or two should take your portfolio back to December, 2017 values.

 

 

** Source: Wall Street Journal, “Oil Prices Tumble as US Output Surges,” print edition, February 8, 2018 and WWM blog post dated May 25, 2017 and its sources.

 

Disclosure: We recommend stock investments in a globally diversified portfolio, which is quite different from just owning the US based S&P 500 Index. The S&P 500 Index is used above for illustrative and educational purposes only.

 

 

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