Along with many others, we have been calling for a stock market correction for many months now, and it appears that it is now finally happening. After setting a new all-time record for the longest period of time without a 5% decline, posting 15 straight months of positive returns, and establishing numerous historic lows for volatility (VIX), the S&P 500® Index has fallen 7.8% over the past six trading days, while the VIX has more than doubled. Before we panic, let’s consider the following:
- This takes the market back to the level it reached on December 15 of last year, so it has wiped out less than two months of gains in the midst of a roaring bull market.
- The economy and earnings growth are strong and will likely be buoyed by the recent tax cuts and the global economic expansion for an extended period of time.
- This downturn represents a healthy correction for a stock market that had produced a gain of more than 26% over the past 12 months and the 11th best return for the month of January since 1950.
- Declines of 10% or less are very normal and allow investors who have missed out on gains an opportunity to get into the market at a cheaper price, i.e., “buy the dips.”
All that said, we are dubious that stocks will return to the “straight up” pattern that we’ve witnessed since November 2016, mainly because the key factor in the long-running bull market has been low inflation and low interest rates. More specifically, note that the recent sell-off was exacerbated by the January employment report that showed wages growing at a 2.9% annualized rate, the strongest since 2009. Such strong wage growth could well lead to higher inflation, which in turn leads to higher interest rates. In fact, the yield on the 10-year U.S. Treasury bond has risen from 2.41% to 2.85% since the beginning of the year, while the Federal Reserve is expected to raise the Fed Funds rate by at least another 0.75% this year. The good news is rates and inflation are supposed to rise when the economy is expanding — it’s just been so long since we’ve seen this phenomenon that we aren’t sure how to react.
As the year progresses and the tax cuts kick in, we expect economic growth to expand and inflation and interest rates to gradually move higher. This spells the end of the “Goldilocks” environment that drove stocks higher in 2017 and a return to more normal levels of volatility. In addition, this is a mid-term election year for Congress, and we have historically seen double-digit drawdowns when mid-term elections take place. There is no need to panic, but it may be a good time to evaluate portfolio allocations and consider de-risking to a degree into asset classes that perform better in a more volatile environment. Ultimately, as long as the economy continues to grow at a reasonable pace and investors don’t panic, we believe this correction is a healthy development for the stock market.