To paraphrase the Florida Keys’ own Ernest Hemingway, big shifts in the stock market often occur “gradually, then suddenly.”
Following the latest jobs report on Friday, the Nasdaq is now in correction territory, defined as a 10% decline from recent highs. The S&P 500 has pulled back 5.7% from its high three weeks earlier, while the Dow has been steadier with a decline of 3.5%. The VIX, often described as the market’s “fear gauge,” has surged to its highest level since early 2023. And the 10-year Treasury yield has also now fallen below 3.8%, a sharp decline from 4.7% only three months ago.
Nonetheless, I expect the selloff in both bond and stock markets to be short-lived.
One major reason is that most incoming economic data is still positive. There is not enough bad data to conclude a recession is coming.
That soft July employment report on Friday is inconsistent with plenty of other recent data on economic activity. There are positive signs in restaurant bookings, TSA air travel data, tax withholdings, retail sales, hotel demand, bank lending, and even weekly box office grosses.
Economic growth (GDP) in the second quarter also reached 2.8%. Inflation is now largely under control – per the Fed’s preferred inflation gauge, the PCE price index – which was at 2.5% in June on a year-over-year basis. And despite those recent nonfarm payroll numbers coming in a bit light relative to forecasts, the absolute level of U.S. unemployment of 4.3% is still not bad historically.
In short, there is no reason to panic about the economy.
A Trifecta of Nerves
Instead, this market drop seems attributable to three other issues:
- The unsustainably high valuations of technology companies boosted by hype around AI. Whether AI and large language models can live up to their lofty promises has yet to be seen, so it’s not surprising tech investors are growing anxious about seeing a return on the billions being invested in those new technologies.
- The unwind of a decades-long strategy popular among hedge funds known as the “yen carry trade.” Details aside – it’s not the first time global markets have sold off because big, fast-money investors had to untangle complicated, heavily leveraged trades in a hurry. We are likely through the worst of that unwind now, though.
- Investors are worried that the Fed has waited too long to cut interest rates.
Ironically, current macroeconomic conditions – inflation returning to 2%, low but rising unemployment, falling interest rates, and double-digit stock market gains – are exactly what investors had hoped for at the start of this year.
And market expectations in 2024 have been particularly fickle.
In January, many investors believed the Fed would need to cut rates several times this year, to ward off an imminent recession. Expectations then shifted after a few hotter-than-expected inflation reports, with the Street speculating the Fed would not cut at all this year. Now, markets expect the Fed to cut in September – and possibly at each subsequent meeting, too.
The Fed attracts a lot of criticism, but it’s hard to get monetary policy right, even among the backseat drivers.
It is true the economy is slowing slightly – as the Fed intended – but we should still see a “soft landing.”
Historically, “hard landings” have usually been the result of policy missteps rather than just bad timing by the Fed. The Great Depression, for instance, was worsened by the Fed’s decision to tighten monetary policy at a time when expansion was needed. Similarly, the high inflation of the 1970s can be attributed to the Fed’s overly accommodative stance when prices were rising rapidly. In both instances, the Fed’s actions were essentially the opposite of what economic conditions required, underscoring how severe policy mistakes can be.
Where does the Fed stand today?
Few economists would argue that the Fed has made the wrong moves lately – just that those moves have not been timed well. And while many may wish the Fed had cut rates at its last meeting, the good news is that it seems clear now that the Fed will cut rates at its next meeting in September.
In addition, the Fed still has an awfully big lever it can pull to help the economy if necessary. That tool is the federal funds rate, currently sitting at a 23-year high of 5.5%. So the Fed has plenty of flexibility and firepower to support the economy quickly if needed.
The Bottom Line
Stocks never move straight up for long – so how we react to market volatility is perhaps more important than volatility itself.
The S&P 500 has now experienced its second 5% or worse pullback this year. As the attached chart shows, that is still below the average of 4 to 5 pullbacks in the average year – and dozens during bear markets.
The market’s rise in the past year, with remarkably few bumps, has been one of the smoothest in decades. With the market pulling back in recent weeks after that strong year-to-date run, I view the recent market sell-off as largely profit-taking and repositioning by large, fast-money investors.
Now, one day there may be other challenges investors will have to navigate after the previous decade and a half of excessive spending and easy money – but the bond market doesn’t seem concerned at all about that particular risk at the moment. So, neither am I.
To be sure, this fall we’ll see a bitterly contested U.S. presidential election as well as a rate-cutting cycle – so some volatility should be expected.
But those are not reasons to lose focus when investing long-term.
And we will mitigate those future risks the same way we have managed prior ones:
By being disciplined value investors.
Please let me know if you have any questions. And thank you for the patience.
Cale
Disclaimer: This post nor any of the material linked to herein in any way constitutes investment advice. Individual results will vary depending on market conditions and timing of initial investment. Investing may cause capital loss. The publication of this information is in no way a solicitation or offer to sell securities or investment advisory services.