Another Bad Day in the Market: Now What?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 23, 2018 3:15:06 PM

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marketWhen I started writing this today, the S&P 500 was down about 2 percent (though it's come back up a bit in the past few hours), giving us another bad day in the market. Overall, we are down approximately 8 percent from the peak. Once again, concerns are rising over whether this is the big one, the repeat of 2008.

Normal volatility?

It may be, but not yet. Historically, we have not seen extended bear markets when the economy is as good as it is now. We have seen sharp but short pullbacks, most notably in 1962 and 1987, as well as in early 2016 and 2018. That type of pullback looks very much like what we are in the middle of right now. At an 8-percent drop, we are still well within the range of normal volatility and not even close to something worse. At high prices levels, normal volatility looks even scarier than it is. Still, it is just normal volatility.

The reason I say this is because with prices as high, by historical levels, as they are, there is quite a bit of confidence baked in, and confidence is notably variable. When you consider everything that is happening right now—Italy, Brexit, Saudi Arabia, a Chinese growth slowdown, trade wars, the pending U.S. midterm elections, and I could go on—almost all the news we see every day is bad. The surprise is not that markets are reacting; it is that markets did not react sooner and that they have not reacted harder. As I’ve said before, we can expect more volatility. But with strong economic fundamentals in place, it is reasonable to conclude that this turbulence is probably just another 2016 or 2018 (i.e., a sharp pullback that will be reversed in the next couple of months).

Time to get nervous?

With all that said, it is now time to think seriously about how my rosy scenario above could be wrong. The S&P 500 has broken through its 200-day moving average and seems likely to stay there for a while. If that happens, you could make a good argument (which I do in my book, Crash-Test Investing) that it is time to derisk your portfolio because the chances of further downward moves are significant. From a market perspective, the case for getting nervous is real and getting stronger.

From an economic perspective, the case for nervousness is also getting stronger. Housing, an important leading indicator, is rolling over, as construction and home buying wilt under the effect of higher home prices and rising interest rates. Wage growth is picking up, which will hit company profit margins and push inflation up. The Fed has signaled it plans to keep raising rates, which will be an increasing headwind to growth. Trade problems are starting to affect prices and growth and will get worse over time. Growth is already starting to slow, and that slowdown could get worse quickly.

Put all these factors together, and the risk is that investor confidence, already under pressure, will crack and take prices down significantly. This scenario is exactly what we saw in early 2018, early 2016, and 2011. It could happen, and it could be bad. The odds are still against it, but the chances are certainly rising.

Now what?

Now is the time to make some decisions about what you will do and when you will do it, if the decline continues. If the 200-day trendline is your threshold, then keep an eye on your next scheduled portfolio update. If you don’t like the 200-day, the 400-day is another good trip wire, which is now at 2,630 for the S&P 500. Personally, I manage some of my money using my book’s methods. But I am not as risk averse as some, so I also use the 400-day trendline. I am paying attention but not yet doing anything.

The reason is that, per history and the fundamentals, the likely outcome is that the market recovers in reasonably short order. All of this volatility has exactly as much long-term effect as the stock market crash of 2016 (such as it was) did. Almost no one remembers that crash today. Why? Over time, it didn’t matter. Which is exactly the point.

We can’t ignore recent volatility, nor should we. What we should do is understand where it comes from, what it has meant in history, and how much risk we are willing to take in our portfolios, and then make changes accordingly. Given all that, another bad day in the markets is nothing more and nothing less than just another bad day—one you likely won’t remember a couple of years from now.

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