What Happened and Why?

After a steady climb for fourteen months, global stock markets experienced a sharp reversal this week. As we write on Friday morning, major benchmarks are 10% below record highs reached on January 25th. It has been a memorable week for the Dow Jones Industrial Average, which sustained 1,000 point declines on Monday and Thursday.

In our year-end letter we noted a few areas of concern, describing rising inflation and rising interest rates as probable for 2018. It didn’t take long! Only a few weeks later, interest rates are indeed higher amid worry about inflation, the latter provoked by a very strong employment report on February 2^nd and a report yesterday on weekly unemployment claims. As noted in our January commentary, higher interest rates can be a “double whammy” for stocks. Borrowing costs go up for businesses and consumers, eventually lowering economic growth potential. At the same time, higher prospective bond returns reduce the appeal of stocks.

Much has been written about technical factors that may have aggravated recent market turbulence. Esoteric “risk parity” and “low volatility” investment strategies, based on borrowing to enhance returns, are getting well-deserved criticism in the wake of spectacular setbacks. The hedge funds that championed these strategies remind us of Warren Buffett’s quip that it’s only when the tide goes out that you realize who’s been skinny-dipping.

What’s Next?

A market correction has occurred, overdue by historical standards inasmuch as the last 10% setback occurred two years ago, at the start of 2016. However, we think a major decline is not probable.

Major stock market setbacks (down 20% or worse) usually anticipate the onset of economic recession, but this risk factor is not evident today. In fact, the Index of Leading Economic Indicators remains in a favorable uptrend, auguring continued growth in the U.S., and most foreign economies are expanding as well. Corporate profit growth, which was excellent in 2017, should be strong again this year based on economic expansion and lower business tax rates. Many companies are rewarding shareholders with generous dividend increases, a manifestation of confidence in future profitability. Inflation is moving up, as we expected, but is not likely to reach “high” levels that would require aggressive interest rate increases by the Federal Reserve.

We stand by the outlook we described in our year-end letter.  Positive but leaner stock market returns are likely for 2018, and occasional bouts of volatility are almost a certainty. In some respects, this is a return to normal. History shows that 5% market setbacks occur 2-3 times a year and 10% corrections happen once every 12-18 months. The “cruise control” conditions that characterized 2017 are the exception, not the rule.

Take the Long View

 Periods of turbulence are always sensationalized by the media, and “market timing” may seem appealing in the aftermath of declines. Yet selling and repurchasing stocks at the right intervals requires extraordinary luck. The more likely outcome is a “behavioral penalty” of lower long-term performance. This is because the timer sells after declines are underway (he believes things will get worse) and later repurchases at higher prices (believing things are back to normal).

The more productive and time-tested approach is to follow a long-term investment policy, structuring an “all weather” portfolio based on appropriate asset allocation and careful diversification.  Bonds and lower-risk alternative investments help control risk, and cash should always be maintained for anticipated withdrawal requirements. With prudent safeguards in place, occasional market declines will not disrupt financial plans.