As stated in our recent Q4 2017 quarterly newsletter and client education presentation, the calm, steadily rising equity market that had been in place since February 2016 was not normal. We did not know when a pullback would come, but we viewed its coming as inevitable. Today’s declines in the Dow and S&P 500 were dramatic, but they were certainly not unprecedented in the context of financial markets history. In fact, since 1937, the S&P 500 Total Return Index has averaged more than one 5.0%+ pullback off unique 52-week highs per year.

As the old trading adage goes, “Markets take the stairs up, but they take the elevator down.” Everyone is searching for why the market fell so much the past two days. We believe the best answer is that just as the equity market rallied strongly with no significant changes in the market narrative, it declined with no significant change in the market narrative. That said, there are some legitimate reasons that added fuel to the fire.

  1. The monthly jobs report on Friday showed a strong increase in average wages. While this is good news for workers and the economy, it may be bad news for the markets for two reasons. First, a significant increase in wages could negatively impact the record high profit margins that many companies are currently enjoying. Second, a significant increase in wages could lead to an increase in inflation, which in turn will cause interest rates to rise as the Federal Reserve hikes interest rates and long-term bond investors demand higher rates of return to compensate. Many investors have used low interest rates to justify current above-average equity market valuation multiples, so rising rates may have a negative impact on both stocks and bonds.
  1. During December and January, investor sentiment showed large signs of shifting in a bullish direction, whether measured from retail investors or trend-following professionals. During this long bull market, one of the reasons we had pointed to as a reason to remain bullish is that investor sentiment had been cautious, there was still a lot of cash sitting on the sidelines. This may no longer be the case, and it makes the market more vulnerable to quick negative sentiment shifts such as we have seen the past two days.
  1. There are many professional investing firms that employ either trend-following or risk parity strategies. These systematic approaches often buy equities when they are going up or when volatility is low, and sell equities when they are going down or when volatility spikes like it did today. This can exacerbate moves in the market in excess of that justified by any fundamental news, and we may see more selling in the coming days simply because it is mandated by their strategies.

Reasons to remain positive:

  1. Corporate earnings have been strong and will be helped even further by tax reform
  2. Global economic growth trends are still looking very positive
  3. As far as we know, there is no news out that justifies a significant sell-off from today’s market levels

As long-term investors, we do not believe in tactical market timing. We recognize that there is no simple formula to know the future direction of the market, and by recognizing what we don’t know, we can eliminate personal biases from our investing process. We believe that sticking to a properly selected target risk level in both good times and bad is the best recipe for long-term investment success. The sell-off of the past two days actually gives you a good opportunity for a gut check of your emotional risk tolerance. At some point in the future, we believe it is inevitable that the stock market will have a major correction well beyond what has been experienced the past two days. If you do not think you will be able to stay the course during such an event, then we believe your target risk level should be revisited. As always, feel free to contact us with any questions you may have about your unique situation, including the risk level of your portfolio.