When you hear that the Dow Jones Industrial Average dropped by over 300 points it gets your attention. It triggers that automatic emotional response which leads you to ask, “Is the market rally ending?” I’m going to start this article by saying “I’m not a cheerleader for the stock market”. As a cheerleader, it’s your job to cheer whether your team is winning or losing. Sometimes the general public views investment advisors that way. “Of course my advisor has a rosy outlook. He wants me to stay invested”.
My view is when the cycle is ending it’s ending. When the data tells us that we are headed toward the next recession, you just have to accept a lower expected rate of return and make the necessary allocation changes to preserve principal during the market downturn. The answer is not always “just hold through it” which is unfortunately the answer that some investors receive from their advisor regardless of what’s happening in the markets and the economy.
What Has Changed?
Whenever you have a big down day in the market the first question you should ask yourself is “What changed?” I know the value of the stock market changed but the question I’m really asking is what fundamental change happened in the U.S. economy to trigger the selloff?
Did GDP growth rate pull back unexpectedly?
Did the monthly jobs report come up short?
Did inflation increase by a large number that wasn’t expected?
Are corporate earnings deteriorating?
Has the leading indicators index turned negative?
These are the real questions that you should be asking. Remember, the economy leads the stock market. The stock market does not lead the economy. Watching the fluctuations in the stock market and using that as a tool to make investment decisions is a recipe for disaster.
- A growing economy typically means higher corporate earnings
- Higher corporate earnings often results in higher stock prices
With that said, sometimes the market is down because it’s reacting to poor economic data. In those cases, the market downturn may be warranted. However, that is not what I think happened yesterday. We did not get a bad jobs number or shortfall in GDP growth. In short, as of yesterday, nothing has changed from an economic standpoint. Days like yesterday are just a reminder of what volatility in the markets feels like.
Higher Volatility Ahead
If you asked me if I expect more or less days like yesterday in 2018, my guess would be more. We are all suffering from “recency bias”. 2017 was this nice smooth ride higher with very few interruptions. When you get used to sailing in smooth waters, a small wave can seem like a tsunami. Below is a chart of the CBEO Vix Index from January 2002 – January 2018 which is used to gauge the level of volatility in the U.S. stock market:
As you can see, we are coming off of historically low levels of volatility and we have to remember that volatility is normal. Every down tick in the stock market is not necessarily a signal that a recession is coming.
The Math Is Different
What if I told you that the market was only down 177 points yesterday? It probably does not trigger the same fear reaction as being down over 350 points. The reason why I ask this question is you have to remember that the price level of the Dow has doubled over the last 6 years. So a 300 point drop in the Dow Jones Industrial Average today does not mean the same thing as a 300 point drop in 2012. On February 17, 2012, the Dow Jones Industrial Average closed at 12,949. Today it sits just above 26,000. In percentage terms, a 300 drop in 2012 equaled a 2.3% drop in the stock market. If you translate that to where the stock market is today, you would need a 598 point drop in a single day to get that same 2.3% drop. It’s just math but we have to remember this when the headlines in the media read:
“The Dow Dropped By 300 Points Today. Traders Are Worried That This Could Be The End Of The Rally?”
While I write these articles to help our clients and readers to become better investors and to put important market events into perspective, I have a special note that I want to leave off on for our clients. When you have that feeling of uncertainty, never hesitate to contact me. That quick phone call just to ask, “Mike, should I be worried?” That’s what I’m here for. Have a great week everyone!!
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.