If you’re a superstitious investor, you might be blaming the recent decline in the stock market on the October Effect, or the theory that stock prices decline in October. This Wednesday, the Dow Jones Industrial dropped nearly 832 points or 3.15%, the third-worst point decline in the history of the market[i]. Don’t start selling all your stocks just yet. To keep things in perspective, the Dow fell 23% on Black Monday in 1987 (also in the month of October, out of interest)[ii]. We’re nowhere near that and the current US economy is quite strong. We’ve experienced numerous mini-corrections in the stock market since the bottom of the Great Recession in March 2009. This is hopefully another mini-correction that was overdue and will bring momentum driven stock prices back to their true valuation.
So, what caused the stock market to tumble? There are a multitude of factors that have brewed from concern to fear, consummating the market correction we witnessed this week.
One major concern is rising interest rates. The Fed has been slowing and consistently raising interest rates since 2015[iii]. During the Great Recession, the Fed was holding the economy together with all-time low interest rates. Now that the economy is stronger, the Fed is raising interest rates to heed off rampant inflation. The fact that the Fed feels the economy can withstand higher interest rates is a positive indicator that the economy is on track.
Rising interest rates create a ripple effect. Corporations have benefited from 10 years of ultra-low borrowing rates to fund business operations and growth. Those days are no-more and the cost of future borrowing will certainly come at a higher cost. Further, during the recession, banks and bonds were offering customers less than 1% in return, so investors were driven to the stock market for better earnings. Now that the 10-Year Treasury is yielding 3.21%[iv], some investors are cashing out their stock investments for a very dependable investment backed by the full faith and credit of the US Government. This drives stock prices down and, in theory, hurts a company’s ability to raise more capital through equity markets cheaply.
Another stock market concern weighing on investors all year has been the possibility of the US in a trade war. On September 30th, the US signed a new trade agreement with Canada and Mexico that replaced the prior North American Free Trade Agreement (NAFTA). The new United States-Mexico-Canada Agreement (USMCA) brought about some relief to investors. However, the US and China have imposed tariffs and retaliatory tariffs on each other throughout the year, giving investors concerns that the tit-for-tat behavior is nowhere close to resolving soon. The rising cost of inputs for US corporations on imported goods paired with higher labor costs, could potentially cut into profit margins and investor returns. This hesitation was evident as stock prices swung up and down weekly, despite strong quarterly earnings reports by corporations.
These conditions created unbearable tension that was finally released through a mini-correction in the stock market this week.
So, what’s an investor to do? The recent stock market volatility can be battled with a well-balanced and highly diversified portfolio. When the stock market declines rapidly, many investors sell their equity investments and reposition into more secure investments like bonds or fixed income. Investors who have been disciplined in asset class investing and held their fixed income allocation during the booming 2017 and volatile 2018 market benefit from this shift. That’s because asset class investors already hold fixed income in their portfolio, so while market movers are jumping in and driving the price of fixed income higher, those who already hold the position benefit from the gains.
Further, those who have employed a diversification strategy don’t have all their eggs in one basket. This week, we saw the technology sector take a sharp decline. Tech stocks have been the darling of the market this year, setting new market highs daily. Apple made headlines for reaching $1 trillion in market capitalization in August of this year. However, on Wednesday, it was one of the most actively traded stocks of the day, losing 4.63%[v] in value. Likewise, Twitter lost 8.47% and Netflix lost 8.3%[vi] in value. Investors who employ a diversification strategy have been locking in gains in the tech sector systematically throughout the year and repositioning those gains into sectors of the market that were underheld and undervalued. With broad diversification, when one sector of the market declines, the impact on the overall portfolio is nominal.
Some news outlets or market pundits will make bold, attention-grabbing headlines announcing the end of a long-run bull market or the start of a new recession. However, their goal to draw viewership or get more clicks online can be irresponsible and self-serving. More responsible commentators will state the obvious – No one can tell the future.
Market corrections are normal and healthy for the overall economy as these “brake checks” prevent market bubbles from developing. Economists have reiterated that the US market is fundamentally strong. This September, unemployment moved to a 49-year low[vii]. Wage growth is starting to pick up, with the median base pay for workers in the United States climbing 1.6% in June[viii]. Corporate profits are high and consumer spending has been strong. Despite increased market volatility, economists feel that good long-term returns are possible over the next couple of years.
These moments present an interesting opportunity for investors to re-examine their portfolios and overall investment philosophy. For ambitious investors, it might present a buying opportunity. If you feel your investments need a review, reach out to a Certified Financial Planner™ or a trusted investment advisor for a second opinion. They’ll be happy to ensure you’re on the right track for the market to come.