Market correction or end of the bear's slumber?

A perspective from E*TRADE Securities1

10/19/18

Even if you’re a fan of state fairs or amusement parks, last week’s carnival fun house might have been a bit much. By the time it was over, investors felt like they’d gone on the Tilt-A-Whirl after a generous helping of cheese fries.

October holding true to form

Just as the roller coaster began its decent, we revisited the perils of October, outlining the month’s ghoulish history of volatility, along with a propensity for sizeable gains. In a sense, October encapsulates the classic risk/reward conundrum. Sure, the month has been a winner when you consider nearly two decades of US large-cap performance, but it has come at the cost of some seriously stomach-churning turbulence. This October appears to be no exception: In short order, a host of market crosswinds morphed into a vicious market downdraft.

S&P 500 Index, 10/8 - 10/12

Source: FactSet Research Systems

How could this have happened given the strong underpinnings of the US economy? Was it merely a long-overdue correction? Or something more telling?

A market pullback with many sources

Rising interest rates: Many seemed eager to blame last week’s setback on the Federal Reserve, with President Trump going so far as to say the Fed had “gone crazy” by hiking rates exactly as it had telegraphed it would. Attempts to undermine the central bank’s independence notwithstanding, the president’s objection is not entirely out of left field. There is little doubt that raising interest rates could create headwinds for economic growth. But that is by design. Inflation is running right at the Fed’s long-term target of 2%, and Trump’s own appointee, Fed Chair Jerome Powell, has made no secret of his desire to contain inflation through monetary tightening.1

Tax cuts: President Trump is fond of saying that the US economy is running on “rocket fuel.”2 Given the potential for economic overheating, it could be argued that regular unleaded would have sufficed. While last year’s tax cuts greased the skids, many economists believe they were wholly unnecessary. The US economy had already been growing at a steady clip, but now it has been put on a credit card, with the stimulus of tax cuts exploding the federal budget deficit during a period of economic expansion. Investors may be wising up to this fiscal malfeasance, but any talk of deficits in Congress has taken a back seat to cheering on the bull market. That could have repercussions when the party is over and tough decisions have to be made just as the economy potentially decelerates—or even contracts.

Tariffs and trade wars: This is a big one. Free trade has been a cornerstone of global economic policy going back to World War II. But a new brand of protectionism has taken hold, and not just in the US. To what extent tariffs and trade restrictions affect Q3 earnings remains to be seen, but enough corporate chieftains from manufacturers like General Motors, Whirlpool, Harley-Davidson, and Kimberly-Clark have issued warnings for investors to be wary. Clearly, the upcoming earnings season will bear watching.

Elections: Elections are often cited as a rationale for October volatility, but it’s difficult to quantify this thesis. This time around, political pundits believe there’s an above-average chance that Democrats will retake the House of Representatives after November’s midterm elections, while the Senate map portends continued Republican control of the upper chamber. What does this mean for investors? Less clarity around economic policy for one thing. The potential end of one-party rule is either good or bad, depending on your perspective, but uncertainty can rattle the markets.

Where do we go from here?

Buy-and-hold investors already know what to do: Get on with their lives. More active traders may want to keep track of our daily active trader commentary and consider strategies for rising interest rates. In either scenario, it helps to take the long view and develop a financial plan for getting through the rough patches with a minimum of worry. After all, consider the following chart:

Source: FactSet Research Systems

That's the good news for equity investors. Despite experiencing a couple severe dips, including the greatest economic downturn since the Great Depression, the S&P 500 recovered each time and has generated an annualized total return of nearly 7% over the past 20 years.

It could get rocky in the weeks leading up to November 6, so fasten your seat belts. And remember that a diversified portfolio can be one of the best buffers against market volatility.

But go easy on the cheese fries just in case.

1.  “Transcript of Chairman Powell’s Press Conference,” Board of Governors of the Federal Reserve System,”  September 26, 2018, https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180926.pdf

2.  “Trump: Tax Cuts ‘Rocket Fuel’ For Economy,” AP News, November 29, 2017, https://www.apnews.com/e750d8d43748422b89b673f03b3f86ed