The markets have had a good run for the past six weeks, with a return through Tuesday of more than 7 percent for the S&P 500 Index. The run seemed to have been predicated on the fiscal cliff deal at the end of last year, the impression that the Federal Reserve (Fed) would continue to support the economy with low interest rates, the resolution of the European debt crisis, growing corporate earnings and profits, and a real economy in steady recovery. Retail investors had started pouring money back into equities, and there was talk of a “Great Rotation” out of fixed income and back into stocks.
Well, the real economy is still in recovery, but the other pieces of the puzzle are looking ragged. Yesterday, the Fed published minutes from the most recent meeting of the Federal Open Market Committee, showing that the committee is not unified in its decision to maintain purchases of Treasury and mortgage securities. This raises the possibility that rates might increase much sooner than the market had thought. Sequestration has also moved back to the front pages of the major papers, suggesting that the political risk from Washington is rising. In addition, Europe looks to be very much in play again, as Silvio Berlusconi has a shot at the Italian elections— which could blow up the current austerity-driven political consensus—and the economy of the eurozone as a whole continues to weaken, driven primarily by France.
The only real piece of news yesterday was the Fed minutes, casting doubt on the indefinite continuation of asset purchases. That prompted the markets to reassess whether the outlook was really as unclouded as it had seemed, and they decided that it wasn’t. The S&P 500 dropped 1.24 percent, and it has dropped again today, back to close to the 1,500 level.
Fewer than two days of market declines do not a bear market make, but the drop, even if it turns out to be brief, illustrates the potential effect of risks erupting. Since the election, with a brief drop at the end of last year, the market has done very well. We appear to be due for some kind of retreat, and any one of several risks could be the precipitating factor.
Besides the Fed’s pullback and the troubles in Europe, other risks include Iran’s nuclear program, which hasn’t gone away; the Chinese cyber war on the U.S. and its companies, which is now making front-page headlines; the ongoing confrontation between China and Japan; the continuation of record earnings and profit margins for U.S. companies; the political risk in the sequester; the debt ceiling, which will soon show up again; and the pending possible government shutdown. This list is far from complete, but any could induce a market retreat.
The trend for equities is still up, but it is based on a presumption that things will continue to go well. The real economy continues to heal, but the financial markets have more than priced that in. When you look at your investments, be aware that, in the short term, even one of these risks could hit the market—possibly hard.