After a strong January, with the S&P 500 up 5.7%, equities have reversed sharply so far in February, and those year-to-date gains have been lost.1 This follows an extended period of low volatility — the market hadn’t pulled back by 5% or more since June 2016,2 and investors in large-cap equities enjoyed a 22% return in 2017.3
On average, markets historically have pulled back by 5% three times in any given year.4 Since 1980, the S&P 500 has had an average intra-year decline from peak-trough of 13.8%, but the market rose in 29 out of 38 years.5 Last year, the peak-trough decline was just 3%, the smallest intra-year pullback since 1995.6
Meanwhile, economic and business fundamentals are quite strong. The U.S. economy is expected to grow around 3% this year,7 and unemployment is hovering at a low 4.1%.8 We have been hearing from corporations over these past couple of weeks, and the news is compelling. So far, earnings in the fourth quarter are up 13.3% versus the fourth quarter of 2016; 82% of the companies are beating analysts’ expectations, and they are providing robust outlooks.9 Earnings are now expected to rise almost 19% in 2018, up from an expected rise of less than 14% just a month ago.10
With the economic and corporate good news comes the concern that it is too good. Last Friday’s jobs report, which showed job gains of 200,000 in January, also showed a gain in wages at an annual rate of 2.9%.11 Over the past several weeks, the 10-year Treasury yield has risen from 2.4% to 2.8%.12 As rates rise, they become more competitive with equities, and equity valuations can compress (i.e., price-to-earnings ratios can drop, which likely means equity prices can drop).
As markets now battle between strong business conditions on one side, and inflationary fears and rising interest rates on the other, volatility has picked up. It’s been a while. We have to adjust — just getting back to normal volatility will feel pretty rough.
What to do?
We stick to our plan — staying well-diversified, keeping our investment choices simple and effective, and operating as efficiently as possible by keeping program costs low and tax liabilities well-managed and limited. Where we can harvest losses for tax purposes, we will.
Traders and trading strategies can overwhelm fundamentals over short periods of time, but ultimately markets reflect economic growth and corporate success. We will follow our long-term discipline — rebalance where appropriate and maintain high confidence in our planning and in our investment program.