As most of us know from the flood of news coming out of Wall Street, the Dow Jones industrial average recently took a 1,600-point tumble — the largest single-day drop in Dow history. The volatility persisted throughout the week with both dramatic ups and downs.
Such swift, sharp, unforeseen corrections strike fear into the hearts of all investors. But now is the time for us all to take a deep breath, step back from the carnage and remember a few critical points regarding the market.
Sure, the headline of “largest decline ever” makes for great news, but let’s put this in context. Remember that percentages matter far more than individual points when analyzing market movements.
At the closing bell, the Feb. 5 cascade lower represented a 4.6 percent move. This doesn’t come close to the record 22.6 percent decline we saw on Oct. 19, 1987. In fact, this recent Dow move doesn’t even crack the top 10 in terms of the worst daily declines on a percentage basis. Putting the correction into the context of broader trends, the Dow is close to the flat line for 2018, and has registered an approximate 20 percent gain over the past 12 months, despite the recent correction.
Mathematically speaking, as the Dow (or any index for that matter) moves higher, one point has less influence on the percentage change. Even as the Dow climbs, three-digit point moves will still grab headlines. But we do well to remember that triple-digit point changes just aren’t what they used to be.
Consider other market dips — in the past two decades (18 years, to be precise), there have been 10 other times when the Dow has dropped 600 points or more. In the past when the Dow traded at much lower levels, those 600-plus-point drops represented much larger percentage moves than what we have recently experienced.
Math and history aside, psychologically we still feel triple-digit moves on the Dow represent major occurrences. This is probably because it wasn’t that long ago when a 100-point move on the Dow was a significant deal, and it remains so in the minds of investors. But the percentages matter most, and things have changed as the Dow has continued to rise to new levels.
For instance, if we think back to just under a decade ago to March 2009, a 600-point move on the Dow represented an almost 9 percent shift. Today, that same 600-point change is only 2.5 percent.
I agree with other analysts that this is a large move on any given day; the market history of volatility has averaged about 0.75 percent per day. So, a 2.5 percent daily shift isn’t something to be taken lightly.
Obviously, this kind of volatility isn’t welcome or wanted. Perhaps not as obvious, however, is that they are to be expected. Let’s talk about why.
1. Overall, 2017 was a docile year for markets, with record low volatility. This “sleepy bull” no doubt led to optimism, elevated valuations, and general investor complacency. A perfect cocktail for a long-overdue pullback. While the speed of this decline alarmed many investors, elevated volatility is something I’ve talked about before and, frankly, am not that surprised to see.
2. Sometimes good news can be bad news. What I mean here is that recent economic good news has translated into bad news for the markets.
We’ve had a spate of “wins” in this economy, not the least of which is that the unemployment rate is down to 4.1 percent. If this rate moves much lower, we’re likely to see wages move higher. This creates the potential for significant wage inflation. When this number hovers too high, it’s a warning sign that a recession may be around the corner.
Wage inflation has moved higher, and clocked in at 2.9 percent for January. This piece of the economic equation is good news for workers, but also can foreshadow the end of an economic cycle. I’m not speaking about an immediate, abrupt end, but a move toward the latter days of expansion.
Another area of good news/bad news is in the realm of interest rates, which have been on the rise. You may remember my “red zone” level of the 10-year Treasury yield (an important proxy for interest rates) is 4.5 percent. We started this year off at 2.4 percent. Now we are already at 2.8 percent, a 15 percent increase in the level of interest rates in just one month. We still have a long way to go before we hit this interest rate red zone, but markets are taking note.
3. While unwanted, this correction may have been long overdue. While we’ve outlined several fundamental factors that can take the shine off equities, perhaps the most important variable in this recent correction is the general lack of volatility and absence of even a minor blip over the past two years.
Let’s look back at other corrections for context of the one we’re experiencing now. Before the recent market pullback, we had gone over 80 weeks without a mere 5 percent correction. For some context, 5 percent corrections have happened on average every 10 weeks. We had gone over 100 weeks without a full 10 percent correction, when 10 percent corrections have happened on average every 33 weeks. As of last week, both of those correction levels were finally breached.
Quite frankly, this dearth of corrections meant the market was ripe for a corrective phase and some consolidation.
Now that we’ve talked it through and delved into the good-bad news, let’s focus on some solidly good news. And this isn’t Pollyannaish; it’s reality.
This January was the 11th best opening month since 1950. Looking back at the 20 best starts to the year: The market’s average gain came in at +23 percent with no down years; and the average pullback was 10 percent during these years, with the most severe coming in at -34 percent. Turning to history shows us that pullbacks, no matter how unpleasant, are a normal part of investing.
As we weather these market storms, remember to keep your eyes on the big picture. We are in a place also marked by reasonable valuations, a healthy economy and fiscal stimulus on the way courtesy of the recently enacted tax reforms. Long-term investors should welcome corrections because they understand such dips are part of the process. Do yourself a favor and keep this point in mind during 2018, a year that is looking to be far less placid than 2017.
The original AJC article appears here.
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