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In the 15 months after the presidential election, the stock market rose as if it were on rails. Nothing seemed to deter its rise, whether it be rich valuations, political chaos or nuclear weapon jitters. As the calendar turned to February, market volatility returned with a vengeance.
The Dow Jones industrial average dropped more than 1,000 points twice over the past two weeks. These were the first four-digit-point-loss days ever and were predictably sensationalized in the media. Of course, what really matters most is the percentage loss, and while both were in the 4 percent range and significant, they still ranked well down the list to other historical percentage-loss days.
On 80 percent of trading days, the market’s change is within plus or minus 1 percent. Today, with the Dow at 25,000, a 100-point move of .0.4 percent doesn’t merit a mention. Mathematically, as the years go by and the market treks higher, larger daily point moves will become commonplace. It wouldn’t be a stretch for the DJIA to cross the 50,000 level by 2030 (a 6 percent annual return for the next 12 years). At that point, 250- to 500-point days would be common.
The abrupt end to the tranquil market set off all sorts of alarms. Pundits were trotted out to provide either their calming opinions or ominous predictions of what the future holds for investors. Investor sentiment “did a 180,” from fear of missing out (FOMO) to fear of being in (FOBI). As the market climbed in January, about $100 billion of new money flowed into equity mutual funds. Then, during the first week of February, investors pulled $57 billion out of the SPDR S&P 500 ETF, the largest ETF in the world, as volatility jarred the market toward a 10 percent correction.
Many explanations have been offered as the cause for the market’s indigestion. Some blame this jolt on exchange-traded notes, or ETNs, that were structured to short the VIX (volatility index). These ETNs went in a matter of days from providing reliable returns to having a value of zero. Wall Street had issued $8 billion of these arcane securities dreamed up by their derivatives departments and are now scrambling to placate investors who were sold the products.
More likely, the aging bull market has hit an inflection point, where the Fed has ended its quantitative-easing operations and is transitioning toward interest-rate increases. The central bank has determined the economy has mended and wants to restore interest rates toward more normal levels. Stocks were reacting to the closely watched 10-year Treasury note’s touching 2.9 percent, a four-year high.
How fast interest rates increase will be determined by inflation concerns, a stronger economy and growing budget deficits.
Contributing to higher rates is a projected increase in the supply of Treasury bonds. The increase is a byproduct of the government’s discontinuing its purchase program and the need to issue more bonds to offset tax reform and deficit spending.
Rising interest rates act like gravity on business values and, hence, stock prices. Higher rates lower the present value of assets and price-to-earnings ratios decline. If rates do not move too high, too quickly, stock investors should still enjoy reasonable returns. But investors should reduce the unrealistic expectations they held just a few months ago.•
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 317-818-7827 or ken@aldebarancapital.com.
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