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When Normal Feels Abnormally Scary

It made for dramatic headlines: “Worst point decline in history.” However a particular media outlet frames it, it sounds distinctly alarming.

So it is not entirely shocking that investors were alarmed at reports that the Dow Jones industrial average fell by nearly 1,600 points on Monday and ended the day down 1,175 points, the biggest single-day point decline in the Dow’s history. The Nasdaq composite and the Standard & Poor’s 500 index also slumped, and the sell-off extended into Asian and European markets on Tuesday. While the drop may have been jarring, it is an excellent reminder as to why it is so important for individual investors to maintain a long-term view and to try to avoid dwelling on day-to-day market news.

Every investment professional knows that markets move cyclically, which means that good times can’t last forever. No investment can grow indefinitely with no downturns, and recessions are a normal part of the economy. It has been almost nine years since the last U.S. recession officially ended, and many people have gotten used to seeing their investments march steadily upward with minimal volatility. But market pullbacks are necessary to keep stocks from overinflating, and they provide investors stuck on the sidelines a chance to buy in. Even if stocks’ bumpy start to the week is a sign of things to come, it does not necessarily mean anything particularly abnormal is going on.

That said, I am not convinced that this downswing heralds the beginning of an extended bear market.

In my view, we are seeing a combination of two factors. First, this is a return to earth for investors who were overly optimistic about stock prices, which had gone up for 15 months in a row. While there is still plenty of good news these days regarding the economy and corporate earnings, investors were bound to find some excuse to sell and take profits eventually. This move doesn’t even yet meet the criteria for a market correction, which is defined as a 10 percent drop from the prior market peak. Monday’s downturn essentially eliminated stocks’ appreciation so far in 2018, bringing us back to where we were a little over a month ago.

Second, we have seen a recent upswing in interest rates and inflation expectations, which together have increased investor uncertainty. The movements have not been huge, but considering how low the baseline for both interest rates and inflation has been in the past few years, even small moves draw outsize attention.

At this point, investors seem to be taking good news and turning it into bad news. The recent jobs reports have shown that not only is the labor market very strong, but wage increases are also finally starting to pick up steam. The recent tax cut will boost corporate earnings and put more money in people’s pockets – employers, employees and investors alike. The low level of interest rates over the last few years was due in large part to economic stimulus and was never going to be sustainable indefinitely. As the economy recovered, both interest rates and inflation were bound to rise to more normal levels; they have begun to do just that. Still, the yield on 10-year Treasuries has risen less than 1 percent (from about 2.0 percent to 2.8 percent). Interest rates still remain well below their long-term averages, and the recent modest increases have not triggered any alarm bells as far as my colleagues and I are concerned.

The sharp market downturn also coincided with a changing of the guard at the Federal Reserve. Janet Yellen’s last day in the top job was Friday, with Jerome Powell poised to take the reins. Yellen’s Fed was conspicuously dovish about inflation, and she was very conscious of not raising rates too fast or too far, thus potentially choking off an economic expansion. Powell may not run a noticeably different Fed – many people expect him to largely follow Yellen’s course – but the mere fact that Powell is an unknown quantity has heightened investor uncertainty, especially since he arrived just as wages and other inflationary signals were gathering a little steam.

It is worth remembering that Americans are in a much better financial position than we were a decade ago, and that while nominal household debt levels are higher, household debt-to-income levels are nowhere near their pre-recession peak. The labor market is tight and stock prices are high, but there is no obvious place in the economy displaying some major distortion comparable to the dot-com era, the housing bubble, or the inflation and energy shocks of the 1970s and ‘80s.

If it looked like the economy was softening substantially, the Fed would, at a minimum, delay future interest rate hikes. It might even cut rates. So the market’s fear of additional rate increases rests on a built-in assumption that the economy will continue to do well overall. And if that is true, then rate rises should not impair corporate profits, although they could act as a drag on stock prices to some degree.

So might stocks’ value decline further? Sure. Could stocks go down significantly and for an extended period? It is certainly possible, though I doubt it is the likeliest scenario. Are we on the brink of another crash? It is hard to see what circumstances would put us there. Especially with all the economically stimulating effects of the new tax law, I would say it’s not very likely at all.

Investors should step back and take a deep breath. Part of what makes this week’s turbulence so unnerving is that it stands out so much in context; a nearly 5 percent drop in 2009 would have been almost a matter of routine, but today it seems jarring. As Heather Long wrote in The Washington Post: “The big takeaway for most people who have a 401(k) or a bit of money in the market is that we have just experienced almost unprecedented calm in the markets. Now things are likely to get more choppy. That’s normal in historical terms, but we just haven’t seen it in a while, so it feels odd.”

Days like Monday are never fun, but it should take much more to make investors question the merits of a well-constructed, long-term investment strategy. As long as economic growth and corporate earnings remain strong, and there are no other unexpected shocks to the system, we believe diversified stock portfolios should continue to perform well in the future.

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