After an extraordinary two-year period of market calm, the major U.S. equity markets slipped into correction territory last week. A perfect storm of investor worries collided over the past six trading days, including inflation, monetary policy, and the unwinding of crowded, complex trades. The result was an unprecedented bout of market volatility, highlighted by 1,000-point swings in the Dow Jones Industrial Average and the fastest retreat ever (nine days) from a record level in the S&P 500 Index to a correction.
In light of last week’s market action, we think it is appropriate to provide investors with perspective on these developments by answering three basic questions:
1. What happened?
2. Where might stocks go from here?
3. What actions should investors take?
We hope the answers to these questions will provide investors with valuable perspective on the market correction, help them figure out a potential path forward, and facilitate informed long-term decisions relative to diversified portfolios.
Equity markets slipped into a correction (defined as a 10% or more drop from a recent high) for the first time since February 2016 as volatility soared, trading volumes surged, and stock prices plunged. The initial catalyst was higher than expected wage growth in the January jobs report, which increased fears that inflation would accelerate and that the Federal Reserve (Fed) would be more aggressive in 2018. Market interest rates then headed higher, the yield on the benchmark 10-year Treasury climbing approximately 25 basis points (0.25%) in the past two weeks. These developments caused the market’s so-called fear gauge, the VIX Volatility Index, to more than double at the most stressful points last week, further accelerating selling pressures.
The potential for higher than expected interest rates had equity investors perplexed in many ways. Would higher rates slow down economic activity? Weigh on corporate profits? Pressure price-to-earnings (PE) ratios? Make bonds a more attractive alternative?
One important driver of the market sell-off was that investor sentiment had become too complacent these past two years and bullish sentiment prevailed as the major equity market indexes trudged higher to record price gains, along with the absence of volatility. This extended period of low volatility also led many institutional and individual investors down the path of crowded, complex trades, which used leverage, or borrowed money, to bet on a continuation of market peace. Once market interest rates and the VIX suddenly turned higher, these trades unwound, causing further selling pressure as traders needed to sell other holdings to raise cash to satisfy their debt obligations from their “short volatility” positions. Essentially, selling begot more selling and equity markets around the globe plunged.