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In recent weeks, financial markets have been on quite a rollercoaster. With fluctuations driven by a mix of economic data, investor sentiment, and geopolitical tensions, it is essential to dissect what is truly influencing these changes and what they mean for your investments.
Recent earnings of some tech companies missed high expectations – the earnings were strong, just not what was expected by the analysts. This, combined with a fear of a recession in the US due to an increase in the unemployment rate, sparked volatility.
Market volatility can be measured by the Volatility Index (VIX), this hit 65.4 which was the third highest period ever recorded after the financial crisis and the pandemic. What you see historically with high VIX readings is high returns in the following 12 months, or at least it has been in the past.
The last three significant pull backs in the Nikkei delivered significant returns in the following 12 months.
October 1987 +25%
October 2008 +43%
March 2011 +18%
When we experience a pullback, investors can think a downturn will continue, which is a recency bias; we think what’s happening now, will always continue, then when it is over you get ‘normal’ historical returns, say 9%pa. If this were true it would take 4-5 years to recover from the downturn, but that’s not how the markets work. Stock market returns are often ‘lumpy’. It is often like a rubber band, the further you pull it back, the quicker it springs forward, most of the time. A good example was COVID, once the markets realised there was a solution and everyone wasn’t going to die, the markets recovered in a matter of weeks, not years.
Once the cloud lifts, the markets will recover, the difficulty is we don’t know when the cloud will lift. This is the period when uneducated investors make mistakes from which they cannot recover.
Recent market turbulence was sparked by a weaker-than-expected unemployment report in the US. The unemployment rate ticked up to 4.3%, higher than the anticipated 4.1%. This news triggered a notable sell-off on Friday, as recession fears began to loom larger.
Historically, a 0.9% increase from a low, like we’ve seen recently, often precedes a recession. This pattern was evident in 2020 and, except for that period, such an increase typically indicates an approaching recession. However, it’s worth noting that not every economic signal is a clear-cut indicator. The current rise in unemployment might not fully justify the panic observed in the markets. Furthermore, the US do not use economic signals to clearly define a recession as we do in the UK, so this is not the same as when we see negative quarterly growth in GDP in the UK.
The question many are asking: is the market’s reaction to the rise in unemployment overblown? Recent data, including a positive GDP report for Q2, seemed to suggest ongoing economic expansion. Yet, the sudden shift in sentiment reflects broader concerns beyond just the unemployment numbers.
While a higher unemployment rate might seem alarming, it’s crucial to remember that the current rate of 4.3% is still relatively low compared to historical averages of around 5.7%. The employment market has been very tight post-COVID, and some softening might actually signal a return to a more balanced economic state.
We still have low unemployment in the US and lots of money ‘slushing around’ so it’s difficult to see a recession occurring imminently, but if it does, perhaps it will not be a deep recession. Recessions come in all shapes and sizes, some are deep, some shallow, some short, some protracted.
As I write this, the S&P 500 has experienced a 9.7% pullback from its all-time high, the most significant decline since 2022. This reaction can be partly attributed to the rapid shift from extreme bullish sentiment to a more cautious outlook. Investors had been overly optimistic, and the sudden downturn might be a correction from that overly positive sentiment. Also, consider that, historically speaking, we tend to see a double-digit pullback roughly once a year.
The Federal Reserve (the US’s Bank of England) interest rate decisions are a hot topic. Recently, market expectations for rate cuts have shifted dramatically. Prior to the last employment report, a 0.25% cut seemed likely. Now, there’s speculation that the Fed might cut rates by 0.50% or even 0.75%.
Jeremy Siegel, a notable economist, has suggested the Fed should enact an emergency 0.75% cut. While Siegel’s insights are valuable, such an aggressive move might be premature. The Fed’s actions should be measured and deliberate, reflecting the broader economic picture rather than reacting impulsively to short-term market fluctuations.
Regardless of short-term rate changes, historical data shows that the long-term performance of the stock market is not overly impacted by the Fed’s interest rate adjustments. Whether rates are high or low, the stock market generally trends upward over longer periods. For investors, focusing on long-term goals, rather than short-term market noise, is typically the best strategy.
Please ensure you hold money you will require in the next five-year in cash and short-term bonds, this allows you to ride out any market volatility.
Market volatility and economic data can often create a sense of panic, but it’s essential to stay informed and focused on long-term goals. The recent uptick in unemployment and subsequent market reactions reflect broader concerns, but they also underscore the importance of maintaining a steady investment strategy.
However, if these movements concern or worry you, please get in touch because more may be on the horizon and you’re far better off aligning your portfolio to your risk tolerance now, than later.
Warren Shute CFP
6 August 2024
