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Stock Market Drop - What Was That?Submitted by Townsend Asset Management Corp. on February 8th, 2018
In just two days, the U.S. stock market dropped about 8.5%, with the Dow Jones Industrial Average shedding about 1,800 points. Certainly, days like that can shake investors’ confidence in their investment strategies and cause concern.
Why did a drop of this magnitude occur?
There was no clear catalyst for the drop – but recent worries about rising bond yields and stronger inflation had hurt market sentiment at a time when the market was already fully valued. The Federal Reserve plans to bump up short-term interest rates throughout 2018 and a recent positive jobs report is a sign for the Fed that inflationary pressures are building, opening the possibility that the central bank may have to raise rates faster than it has forecast in order to keep the economy from overheating – and this is a tricky balancing act.
Are rising inflation and interest rates a good thing or a bad thing?
They are both – depending on timing and interpretation.
When worker wages, interest rates and inflation move up, it is an indication of a positive, growing economy. This is good news as corporate profits can continue growing as can share prices. However, at some point, high interest rates and inflation choke the economy. Corporate profits stall or decline as their borrowing costs go up due to the increased interest rates. As bond yields rise, they compete with stocks for investors’ money, further challenging equity investors.
But, we are a long way from that at this time. Both inflation and interest rates remain at historic low points.
A reassuring factor amid the stock market drop is that people aren’t getting nervous about corporate bonds. The difference between the yield on corporate bonds vs. less risky government debt continues to narrow. If this yield spread was widening, it would indicate that investors had concerns about corporate financial health.
While market drops are no fun, they are a necessary part of investing. We average a 10% drop about once a year, but it has been 2 years since we last saw one. We all must be occasionally reminded that volatility like this is the price we pay for the extra returns we can obtain from being an owner of a business – which is what the market represents. If a 5% or 10% drop keeps you up at night, then it might be time to revisit your investment game plan and risk tolerance. But you should also keep in mind that in the last 6 years the market has doubled, and in the last 9 years it has quadrupled – so some pullbacks are actually healthy and not unexpected. That’s the big picture to keep in mind when we experience uncomfortable investing days.
Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT is president of Townsend Asset Management Corp., a registered investment advisory firm located in Raleigh, North Carolina. Email: Gerald@AssetMgr.com