Finally, a Significant Market Decline

I didn’t mean to put a hex on the stock markets last week.

In last Thursday’s Bob’s Journal, I wondered how investors would react to the next big decline in stocks. I pointed out that a decline of more than 500 points in the Dow would be only a 2% decline. However, such a decline would match the historic Black Monday losses of October 1987 in Dow points, even though the percentage loss back then was about 25%.

The very next day, Friday, Feb. 2, the Dow declined 665 points. On Monday, Feb. 5, the Dow dropped more than 1,600 points to wipe out the strong gains earned in January. The major indices recovered some of the losses on Tuesday.

My main point last week, and stretching back to late last year, is that investors were getting spoiled and losing some sense of history. Meaningful declines in the stock indexes occur regularly during even the strongest bull markets. This bull market was overdue for a correction and perhaps a stronger decline. The very low levels of volatility of recent years also spoiled investors.

My message was that investors should be careful not to panic when a decline occurs and volatility returns. During the early days of quantitative easing back in 2009 and 2010, I referred to the period as “investing in manipulated markets.” The Federal Reserve was using its extraordinary monetary policy to push markets higher. The policy kept interest rates historically low and, over time, reduced volatility in the stock indices in addition to increasing stock prices. With the Fed ending quantitative easing, raising interest rates and gradually reducing its balance sheet, the era of manipulated markets is over, at least for a while. We’re returning to markets that are closer to normal.

A decline in stock indices sometimes indicates troubles in the economy and sometimes doesn’t. We have to look deeper before deciding how to react to the recent losses.

Interest rates were pushed sharply higher by the markets in the last few months, and investors started to notice. They also saw that there is potential for inflation finally to rise above the Fed’s 2% target. I’ve pointed out for a while that inflation has been increasing and the most likely surprise in the near term would be inflation rising faster than is priced into the markets.

I think most of what happened the last few days was investors readjusting stock prices based on higher interest rates. They concluded that rates are likely to be higher than was priced into the markets, and therefore stock prices should be lower. The market declines most likely were exaggerated by the growth of automated trading strategies and index investing.

For now, when I look at the things that really matter to the markets, I don’t see much new stuff.

The economy still is strong, both in the United States and globally. There is no sign of recession. The reliable recession early warning data that I follow are positive. Also, earnings growth is strong. Most major companies beat their earnings estimates for the fourth quarter, and that was after analysts revised the estimates as the quarter progressed.

Even so, the economic cycle has been in the expansion phase for a while, and we could be nearing the end of that surge. As inflation pressures increase, the Fed is likely to continue raising interest rates to keep inflation from rising too rapidly. There’s a risk that action will cause growth to stall. We have to be aware of the risk the Fed could raise rates too much. Given the sharp rise in recent months of market rates that aren’t controlled by the Fed, there’s the potential that investors will raise rates enough to slow growth.

We also have to be on the outlook for the reverse wealth effect. The Fed engineered the economic recovery from the financial crisis using the wealth effect. The U.S. central bank pumped money into the financial system, and that money boosted the prices of assets, especially stocks. That made households wealthier and gave them the confidence to spend and invest. The process increased economic growth and made it sustainable.

The reverse could happen if stocks are trapped in a significant downward spiral. Households would be less wealthy as stocks decline and would worry about further losses. They would pull back on spending and investing.

I’m don’t see signs of these events on the horizon. I’ll keep monitoring the data for the warning signs. In the meantime, I recommend staying with our diversified portfolios and maintaining a margin of safety in all your investments.

NOTE: I prepared this Bob’s Journal a day early this week to accommodate my travel to the MoneyShow Orlando. I will be back on the regular schedule next week.

The Data

Last Friday’s Employment Situation reports are credited by many analysts with igniting new inflation worries and setting off the stock market decline. The number of new jobs was above expectations at 200,000, and the unemployment rate remained at 4.1%.

What triggered the worries was that average hourly earnings increased 0.3%, and last month’s figure was revised higher to 0.4% from 0.3%. That put the 12-month earnings increase at 2.9%. Investors finally noticed that earnings and inflation have been inching higher the last couple of years and began to worry they underestimated future inflation. Some detailed analyses of the data, however, say that much of the wage increases were in a narrow and volatile sector of the workforce. They don’t reflect overall wage increases and are likely to be revised down in the coming months.

Consumer Sentiment, as measured by the University of Michigan, increased to 95.7 from 94.4. That’s a little below the recent high of last October, but still indicates a high level of optimism.

There was mixed news in Factory Orders again. The headline number came in at 1.7%, and last month’s number was revised higher to 1.7% from 1.3%. But capital goods shipments from last month were revised down a little to a 0.4% increase. That number reflects basic business investment, so it’s disappointing to see it reduced. Even so, the data indicate manufacturing is in much better shape than two years ago and growth is increasing.

There also was mixed news from the service sector.

The ISM Non-Manufacturing Index rose sharply to 59.9 from 55.9. That’s a very high level and some of the components of the survey were at or near 20-year highs. The PMI Services Index, however, declined slightly to 53.3 from 53.7. That’s a nine-month low, but still indicates solid growth.

The JOLTS (Job Openings and Labor Turnover Survey) report shows some slowing in the labor market. The number of new job openings declined for the third time in five months. The hiring rate and quits rate have been fairly steady, and the gap between job openings and hires hasn’t changed much.

The Markets

The S&P 500 declined 4.48% for the week ended with Tuesday’s close. The Dow Jones Industrial Average dropped 4.47%. The Russell 2000 lost 4.77%. The All-Country World Index gave up 4.03%. Emerging market equities fell 3.40%.

Long-term treasuries fell 1.47% for the week. Investment-grade bonds declined 0.62%. Treasury Inflation-Protected Securities (TIPS) lost 0.41%. High-yield bonds dropped 0.60%.

The dollar increased 0.60%.

Energy-based commodities fell 1.90% for the week. Broader-based commodities lost 2.51%. Gold declined 1.09%.

Bob’s News & Updates

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