Are We Headed for a Deeper Market Decline?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Dec 11, 2018 12:58:30 PM

and tagged In the News

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market declineWe are now in the third month of the stock market decline, with the S&P 500 getting close to correction territory (i.e., down 10 percent from the peak). Although there have been three attempted rallies, in each case the market has declined again. From a technical perspective, important trend lines have been broken, which increases the risk that the decline could get worse. Is it time to worry?

In the short term, maybe. It is certainly possible that the decline could continue for a while. It is also possible that it could get deeper—maybe significantly deeper. Whether that warrants worry or not, however, depends on the context in which such a decline takes place. Here, the news is encouraging.

Risk and opportunity

The real worry that investors have is that current volatility is a prelude to another 2000 or 2008. In fact, right now it looks much more like late 2015 and 2016. If you remember, we had two back-to-back declines of 10 percent or more, plus another one earlier this year. This decline is about the same magnitude as they were. But after those declines, the market went on to climb to new highs. Given current conditions, we might see a deeper decline, but we also might see a rebound. There is risk and opportunity.

What makes the difference between a pullback that turns around and one that gets worse? In a word: fundamentals. When the economy is growing and when companies are confident and making money, stock prices tend to be resilient. Yes, they can drop—sometimes to a distressing degree—but as long as the fundamentals remain solid, they bounce back. We have seen this over and over in this recovery. When the economy turns, however, and the fundamentals become negative, that is when we get the 2000 or 2008 bear markets that are so damaging.

Fundamentals positive, but what about confidence?

Hiring and economic growth are strong, while business confidence is at decade-plus highs. Companies continue to grow their earnings strongly, and that is expected to continue. From a fundamental perspective, conditions are good, which should support stock prices and moderate any declines.

The other ingredient, besides the fundamentals, is confidence. Investor confidence determines where prices go in the short run. As we can see, it can bounce around quickly and substantially. Looking back at earlier this year and 2015–2016, those downturns—much like the present one—were driven by bad economic or political news. With rising trade war concerns, political disruption in Europe, and fears of an economic slowdown, we can easily see how confidence has taken a hit recently, as well as the effects on the markets.

Recession ahead?

We can also see that confidence tends to bounce back, and stock prices with it, when the fundamentals remain sound as they are now. It takes an economic decline, a recession, to create a sustained downturn in stock prices. Absent that recession, pullbacks tend to be short, although they can certainly be sharp. Right now, there are few signs of an imminent recession, and the most reliable indicators are saying growth will continue for at least the next couple of quarters.

Another key point is that the current volatility is quite modest, although it doesn’t seem that way. The pullback so far, at 10 percent, is actually less than what the market usually does in a year, at around 13 percent. Even a deeper pullback would not necessarily indicate a bear market was imminent. So far, at least, we are nowhere close.

Time to pay attention

Market drawdowns are never fun. By understanding what drives them, however, we can understand when they are likely to get worse—or not. Right now, the market is certainly in the “pay attention” zone but not in the worry zone. If you are worried, take this as a great opportunity to evaluate your investments with your advisor both to better understand the risks and, if necessary, to reduce them. That is the most effective way to worry about the markets right now.

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