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Wow, that was a bad week. After pushing to new high after new high, the market suddenly rolled over. We saw multi-hundred-point declines on several days, culminating in a 666-point drop in the Dow on Friday. This is reportedly the sixth-largest decline ever.
What makes it even worse? We have not seen anything like this for months, even years. The last major pullback was in early 2016, about two years ago. Since then, volatility has declined to close to all-time lows. Put simply, we are out of practice at watching the market go down, which makes a scary day even worse.
We had better get back in practice, though. Of course, the point numbers look scary (666 in particular for Friday, and a bit more than 1,100 points for the week). But when you scale that to the record highs, it looks considerably more normal. Last week, the Dow was down 4.17 percent overall; on Friday, it was down 2.54 percent. These are scary numbers—but much less so than the point totals would suggest.
Volatility is normal
Historically, we have seen declines like this more often than you might think, even in the recent past. On May 17, 2017, the Dow was down 1.78 percent; on September 9, 2016, it was down 2.13 percent; and on June 24, 2016, it was down 3.39 percent (worse than Friday). Going back to the last real drawdown, in early 2016, we saw three equivalent days: down 2.32 percent on January 7, 2.21 percent on January 13, and 2.39 percent on January 15. Plus, there are multiple other examples further back. This kind of volatility is, in fact, normal. On average, it happens a couple of times a year. We have forgotten this as the past two years have been abnormally calm.
If the decline was normal, in the longer scheme of things, it was also not nearly as damaging as it looked. We are still up by more than 2 percent for the year, which is very good since we are only in early February. We gave back some excess gains from January but are still on track for the year. Indeed, by cutting some of the excessive exuberance, this pullback may have laid the groundwork for a more solid and sustainable advance.
Why did it happen?
The biggest reason is the significant increase in interest rates as bond investors got more concerned about inflation. Higher rates are typically bad for stocks. As investors worried about that, perhaps they also thought about political risks (i.e., the pending debt ceiling problem), geopolitical risks (e.g., North Korea), and even corporate risks (e.g., faster wage growth). All of these concerns, which have been largely ignored, probably affected the pullback.
Now that these concerns are back in the market, however, any further effects on price could be limited. In fact, sudden crises of confidence, like the one we are seeing, can knock markets down. But they then tend to bounce back. This is exactly what we saw in early 2016, which is probably the best comparison to today.
The reason is that, if economic fundamentals are sound—as they were in 2016 and are today—there is no real reason for confidence to decline. Sudden declines happen. Then, as investors consider matters more thoughtfully, they buy back in. We may well see further declines from last week, as indeed we are this morning. But the bigger picture remains positive.
A healthy correction
Personally, I will start to pay serious attention when the Dow hits its 200-day moving average. As I write this, the average is at 22,700. That point is quite a way to go from here, down another 10 percent. Until then, any further decline is very likely to be normal volatility reasserting itself. In the face of a solid and possibly accelerating economy, I would be surprised if we even got that far.
As always, though, we here at Commonwealth will be tracking the risks and updating you regularly just in case. Right now, it looks like a normal—and healthy—correction.
