Now that the markets have seemingly calmed down a bit—although there is certainly no guarantee that will remain the case—it is a good time to look at the past couple of weeks and see what lessons can be drawn. Prior to that point, we had not had a significant pullback in two years. Let’s face it, we are out of practice at watching the markets drop. So, what do we know now that we didn’t know two weeks ago?
1) Things are not different this time, and we are not in some new low-volatility world. Investors in low-volatility products, which blew up last week and contributed to the turmoil, were essentially assuming that markets had changed—and that low volatility was here to stay. It doesn’t look like that today.
2) We have to question other assumptions as well. Will inflation always stay low? Maybe so, but the signs say it may be starting to heat up. Will interest rates stay low? Maybe so. Again, there are signs we could be moving back to normal, which would mean higher rates.
3) Big picture, the intended result of all policy since the financial crisis was, simply, to bring us back to normal. In theory, everyone wanted that to happen. But what normal means is more volatility, higher inflation, and higher interest rates. Just what we may be seeing right now, in fact. We are getting back to what used to be normal.
What could the other big effects of normal be?
Let's start with lower stock valuations. Of the major props to current values, low interest rates are at the head of the list. With interest rates possibly on the rise, stock valuations will likely decline. This can, and likely will, be offset by faster corporate sales and profit growth. But it will certainly be a headwind we have not seen in a while.
Another aspect of back to normal is also coming into focus: large and rising deficits. With the tax bill and the recent spending deal, deficits look likely to explode starting this year. Estimates of how much more the Treasury has to borrow through the bond market in 2018 and forward, compared with 2017, are in the hundreds of billions per year. This will be—as it was in the past—another factor pushing rates higher. Interest rates can be understood as the price of money. There is a limited supply of capital in the world. If the demand increases substantially, the price has to go up too. This is independent of the Fed’s actions and, because of that, is something the U.S. cannot control. This, too, was part of what pushed rates up recently and is likely to keep doing so.
The final lesson worth considering here is that the drawback itself, rather than something exceptional, is a move back to normality. Since 1980, global stocks have averaged a 15-percent pullback each year. What we saw recently is not even as bad as it usually gets, on average. It is worth considering that this means it gets much worse than that on a regular basis. Something to think about as we move forward.
The real lesson
The takeaway here, from an investor’s point of view, is that the past two weeks are likely going to be much more representative of the future than is the calm of 2017. If you were scared during the price pull down, prepare to be more scared in the future. But, better than that, take a look at your portfolio and make changes that will let you ride out any downturns with a minimum of worry. The real lesson here? We have to prepare for the fact that “back to normal” may end up being scarier than we thought.