From overdue to overdone?

Thought of the day

by Mark Haefele 06 Feb 2018

What happened?

After 19 months without so much as a 5% correction, the S&P 500 fell by another 4.1% on Monday, bringing its six-day cumulative decline to 7.8%. Market volatility surged, with the VIX rising by more than 100% from 17 to 37. The 10-year US Treasury bond yield has now dropped as much as 19 basis points to 2.68%, reversing its rising trend year-to-date. Broadly speaking, US sectors did not behave in a classic "risk-off" manner, with mixed defensive stock performance. Equity pressure extended into Asia and Europe on Tuesday, with the Nikkei (–4.8%) and Euro Stoxx 600 (–2.0%) selling down.

What triggered it?

Unlike last Friday's 2.1% sell-off, which was likely sparked by inflationary fears when US average hourly earnings jumped to a post-crisis high of 2.9%, there were no obvious economic triggers to today's market decline. Technical factors likely played the lead role in the continuation of selling pressure and the speed of the late-day decline. Both the deleveraging of select institutional buyers with portfolio risk limits, and the market breaching its 50-day moving average, likely accelerated the intra-day drop.

What are the key takeaways?

While the speed of the market declines over the past week is jarring, market declines of this overall magnitude are not uncommon. Over the past 40 years, US stocks have averaged a 10.6% peak-to-trough intra-year decline during bull markets. And the positive fundamental backdrop of above-trend global growth and healthy corporate earnings remains intact. Indeed, amid the day's sell-off, the US ISM non-manufacturing index rose to a stronger-than-expected 59.9 and the new-orders and employment components also rose, suggesting underlying growth momentum remains strong.

In our view, risks of the Federal Reserve raising interest rates too quickly and triggering a US recession over the next two years appear very low. Meanwhile, the median S&P 500 return in non-recessionary years since 1960 has been 15%. Further, following past spikes in volatility (VIX above its 90th percentile), the S&P 500 has posted 12-month gains 87% of the time, with a median return of 22%.

That said, markets are likely to remain volatile in the near term. A single-day decline as sharp as Monday's could force further selling as some systematic strategies are forced into deleveraging, and other investors face margin calls, before longer-term investors such as pension funds begin to rebalance and buy the dip.

For private investors, portfolio diversification is always paramount. The rally in Treasury bonds reinforces the case for diversification, and holding assets uncorrelated to stocks. Investors should consider rebalancing strategies if their portfolio allocations have drifted away from their target ranges. While volatility may persist in the very near term, we remain confident that the bull market remains intact. We may have moved from being "overdue" for a pullback, to approaching "overdone," with this latest technical-driven sell-off.

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