After a period of extended low volatility, the decline in equity indices into the technical “correction” territory (-10% or more from their peak levels) in a very short time period created some anxiety for investors. Such a sudden drop creates uncertainty along with concerns as to what is yet to come. What, if anything, should they do? What caused this to happen?
Naturally we derive some comfort from attaching a reason to why something happened. We feel the need to attribute some logic to events regardless of how illogical or inconsistent the actual explanation may be.
Take the media’s initial spin on the recent correction. According to several different reports, the cause of the decline in equity was a January payroll report that revealed a 2.9% year over year increase in wages. Never mind that folks had been bemoaning this cycle’s unusually slow wage growth as a reason the economy was not achieving its full potential.
Regardless, the report sparked fears of a potential wage-price spiral where higher wages could cause an inflationary cycle. This would not only hurt profit margins, but would lead to higher interest rates which would ultimately slow the economy.
But wait. Just last November, falling interest rates were the problem. After all, as the Federal Reserve was increasing short-term rates, long-term yields were declining.
This flattening of the yield curve led investors to speculate on the possibility of the yield curve moving to an inverted position (where short term interest rates are higher than long term interest rates), a market signal that can presage an economic downturn.
So if you’re following at home, both the potential for higher and lower interest rates were attributed as reasons for worry.
At the risk of being overly simplistic, allow us to posit the notion that there was simply no reason for the correction. The reality of markets is that corrections can and do happen for any reason – or no reason at all.
In reviewing the underlying fundamentals of the global economy (to which we can apply logic!), we see that profit growth is accelerating while valuation levels have improved — in the case of the U.S. market, improved sharply. The yield curve remains positively sloped which incentivizes bank lending, and while an unseen negative event capable of surprising the markets is always a risk, we don’t see anything on the horizon.
Always remember: If you need equity-like returns for some or all of your assets, you need to be in equities the majority of the time. As unsettling as corrections can be, remember that volatility is the price we pay for superior long-term returns.