by: Richard A. Anderson
I am always hesitant when writing about large market drops. It’s a delicate line to walk. In writing something that will calm your nerves and add perspective to what’s happening in the markets, am I calling attention to something that you may not have been aware of? Now that a few days have passed and the markets have rebounded a little, I think it’s safe to address the events that unfolded last week.
The Dow Jones Industrial Average, or the Dow for short, dropped 800 points last Wednesday, August 14th. The reason for the selloff was related to the yield curve. The yield on the U.S. 10-Year Treasury fell below the yield on the U.S. 2-Year Treasury in what is referred to as a yield curve inversion.
Back in March, a different segment of the U.S. Treasury yield curve inverted when the 10-Year yield fellow below the 3-Month yield. Last week’s yield curve inversion was seen as a warning the U.S. could be headed for a recession, as this part of the yield curve has inverted prior to the last seven recessions with limited false alarms.
This came only one day after markets rallied on news the U.S. would be delaying some of the tariffs on electronics and consumer products scheduled to go into effect on September 1st to December 15th.
Wednesday’s market decline attracted tons of media attention. It was even addressed by NBC’s The Today Show, which is a morning news and talk show that doesn’t typically cover the markets. What’s more, CNBC ran a special report called “Markets in Turmoil” for the second time in two weeks.
While the fear inducing headlines and special reports are deliberate attempts to grab attention and boost viewership, it typically serves to promote rather than educate. Here are six things you should know about last week’s market activity before making any decisions with your money.
1. Don’t worry about the points.
The Dow’s 800 point drop last Wednesday was the fourth largest point decline in its history. That sounds scary and it’s certainly a big drop. Yet, when you put it in percentage terms that 800 point drop was a 3.05% decline. In percentage terms, this was only the 380th largest single day decline in the Dow’s history.
For comparison purposes, when the Dow fell 733 points on October 15, 2008, it was a 7.9% decline. When the Dow fell 508 points on October 19, 1987, it was a staggering 22.6% drop.
A 3.05% fall in the Dow doesn’t have the same ring to it as does “Dow has fourth largest point decline in history.” A point move is less meaningful today than in the past because the Dow index level is much higher today than it was even 10 years. Points don’t matter, percentages matter.
2. A 3% daily drop is significant, but not out of the ordinary.
From 1950 through 2018, the S&P 500 averaged about 19 days when it was down between 1% and 2%, 4 days when it was down between 2% and 3%, and 1 day when it was down between 3% and 4%.
So far this year, we are on pace for more 2% down days than in the past, but we are on pace for less 1% down days than average. The reason we may be feeling the pain a little more this year is because the previous 5 years were less volatile.
3. Despite average intra-year declines of 13.9%, the annual return for the S&P 500 has been positive in 29 of the last 39 years.
As of Friday’s close, the S&P 500 is up almost 17% year to date. The S&P 500 is less than 5% below its last all time high reached on July 26th. This type of pullback is well within normal.
Furthermore, from 1950 to 2018, the S&P 500 has experienced an intra-year decline of at least 5% in 65 of 69 years. About 40% of the time the decline didn’t exceed 10%. About 38% of the time the decline didn’t exceed 20%.
4. There have been 25 S&P 500 drawdowns greater than 5% since 2009.
The S&P 500 has had 25 drawdowns of 5% or more during the longest bull market in history that started in March 2009. Each one of those drawdowns was accompanied by a major headline story that invoked fears we were headed for a bear market. We have recovered from all of those.
Do you remember back in 2015 when China abruptly devalued its currency? How about the Greek debt crisis of 2015? Or when Standard & Poor’s rating agency downgraded the U.S. credit rating in 2011?
These three events, plus many more along the way, were the crisis of the day that was going to sink the economy and pull the stock market down with it.
5. An inverted yield curve is a recession indicator.
The yield curve has earned a reputation for foreshadowing a recession because it has inverted prior to the last seven recessions. While the predictive power of the yield curve is clear, the time between inversion and recession is murky. In the past five economic expansions, the yield curve has inverted an average of 21 months before the recession. That lead time has been as short as 11 months and as long as 35 months.
6. An inverted yield curve is not a market timing indicator.
The yield curve may be a good predictor of economic recessions, but its usefulness as a market timing tool is suspect. The yield curve doesn’t spell immediate trouble for the economy and it is historically a positive sign for stocks.
The bottom line is investing is hard and it often tests our patience and discipline. Between trade negotiations, the Fed, a slowdown in global growth, and now an inverted yield curve, the wall of worry for investors has been getting taller by the week.
The historical predictive power of the inverted yield curve suggests a recession will occur sometime in the future. We don’t think that will be in the near term. The yield curve is just one economic indicator that is flashing yellow. Other economic indicators such as unemployment, wage growth, GDP growth, and consumer spending are still strong.
So, we’ll make the argument that investors prematurely pressed the panic button in response to the yield curve inverting for the first time since 2007. We wouldn’t go as far as to say the markets are in turmoil.
Richard A. Anderson is a portfolio analyst at HIGHLAND Financial Advisors, LLC based out of Wayne, NJ. HIGHLAND Financial Advisors, LLC is a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management services to help clients focus on what matters most to them.
Richard graduated from Ramapo College of New Jersey where he earned a Bachelor of Science degree in Business Administration with a concentration in Finance. Richard joined the firm in June 2013 and is responsible for assisting HIGHLAND’s Wealth Advisors in developing portfolios to help individuals, families, and institutions reach their financial goals. He is a Chartered Financial Analyst (CFA) charterholder and member of CFA Society New York. For more of Rich’s thoughts on the markets and sports, follow him on Twitter and connect with him on LinkedIn.