Yesterday saw the largest one-day drop in the financial markets since last year’s election, following a significant drop the previous day. Peak to current, the S&P 500 is down more than 5 percent. What is going on here?
The easiest, and substantially correct, explanation is that markets hate uncertainty. When the Fed announced plans to taper its stimulus program, as clear as it tried to be, it forced the financial markets to recognize that one constant over the past several years—the government’s commitment to stabilize the economy—was being dialed back. Never mind that the Fed’s reason for pulling back was that the economy was improving. The fact that a change was occurring was enough to make investors reconsider—and pull back themselves.
We also saw this in the interest rate markets. Interest rates spiked yesterday morning and bounced around all day, finishing up only slightly on the previous day. As investors tried to figure out the new reality, they sold—and bought—and finally wound up around the same place.
We are seeing the same type of behavior in world stock markets today, with a normal mix of winners and losers. Premarket trends show that the U.S. markets are set to bounce back initially.
As scary as yesterday’s drop was, it is important to keep it in perspective. One of the things I found interesting yesterday was that, even as the market continued its slide, positive reports on the real economy kept appearing on my screen. Housing sales were up, consumer sentiment was up, the economic leading indicators were up. The news on the real economy kept improving even as the market slid.
This matters, because the market ultimately depends on the real economy. With a stronger real economy, we not only will have higher interest rates, we should have higher interest rates. The Fed’s proposed policy shift simply brings us back to normal—which is where we should want to be as soon as possible. For the Fed to publicly signal this shift is a sign that it thinks things are getting back to normal.
The kind of volatility we have seen lately is also normal. The U.S. markets recently completed one of the longest runs on record without a significant correction. Based on history, volatility like we are seeing is not only normal, it is overdue.
A pullback like the one we’re now witnessing in the markets is also healthy. Bubbles occur when markets get disconnected from reality. A pullback provides a very healthy pause for markets to reconnect with what’s actually happening.
None of this is to say the markets will not continue to be volatile or continue to decline for a while. They may. What is clear, though, is that there’s no fundamental reason to worry right now, as current activity is both normal and healthy.
Personally, I do expect volatility to continue until the interest rate markets normalize. I also think further price declines are quite possible, and even probable, in the short to medium term. My concern about the markets is tempered, however, by the ongoing strength of the real economy.
I had originally planned to run a piece today on how the market generally does well in an improving real economy, which I postponed for obvious reasons. But the thesis remains sound. Although we may see some slowing in the real economy this quarter, there is reason to believe that growth will accelerate in the second half of this year and into 2014. Even if the market corrects, the real economy may be laying the foundation for more sustainable future gains.
The road to normality may be rocky, but it will ultimately lead to a more sustainable environment for future market gains. Short-term pain is something we should keep an eye on but, at this point, not be too worried about.