Another Market Correction? Again? Umm... Yep

It appears that we may be in for a test of our investor discipline, yet again. I had hoped we would get away with an uneventful autumn, with the markets gently trending sideways or only slightly downward into the midterm election... the market had other ideas. Both stock and bond markets have posted several of down days recently, and today, the major stock indices broke through support levels with the Dow dropping over 800 points. Fortunately bonds are gaining a bit of traction, softening the blow for balanced investors.

The financial media, of course, always there to help (sarcasm here), has jumped on the opportunity to make it sound far worse than it is - at least so far. "S&P on track for longest losing streak in 2 years" was one headline I saw, because apparently the S&P500 has closed down for 5 days in a row. Never mind that 2 of those days were basically flat trading days, with the "loss" being less than one twentieth of one percent... anything for clickbait, I suppose.

But the fact is that the market does appear to be in the process of pulling back a bit. The good news, however, is that the NYSE Arms Index (which tracks the ratio of falling stocks versus rising ones) and the VIX (the "fear" index) are both relatively muted compared to January's correction and do not suggest any "panic selling" is happening - at least for now. On the contrary, it seems very orderly.

Another headline I read is that "rising rates 'spooks' investors." Umm... okay... how many people out there were actually 'spooked' by the idea of interest rates rising? Didn't that used to be a good thing - especially if you like CD's, money in the bank, and have low credit card debt? I have yet to really see anyone truly terrified of rising interest rates... BUT it does have an impact upon the financial markets.

Here's why:

Pension funds, insurance companies that must back annuities, endowments, foundations, and other large institutions that must create a specific return, or provide specific income streams, typically look for ways to generate that return with the least amount of uncertainty. As such, they build portfolios with very specific components; each one assumed to generate a specific rate of return in the future.

When interest rates rise, 2 things happen. First, the expectation is that new bonds will have higher interest rates than existing ones - and are therefore more attractive than already existing bonds with old, lower interest rates. As such, the bonds that are already in existence will tend to drop in market price (if you want to buy or sell them at that time). However, since the interest that these older bonds must continue to PAY doesn't change (they are fixed contracts) their YIELD (return on market price) actually goes up.

That brings us to the 2nd step. When the price of these existing bonds drop - but their projected returns (YIELDS) go up... then institutions will buy these bonds and add them to their portfolio because they know that as long as they hold these bonds to full maturity - they can generally count on that return, no matter what. This is unlike a stock - whose price or dividend may change often. So big institutional accounts like those above will sell some stock (uncertainty) and buy these bonds (certainty). This reduces risk within the portfolio - and reduces the chance that in any given year, that institution will have to "plus up" the portfolio is stock prices fall... a safety net that pension funds, endowments, and so on really LOVE.

Bond prices are not affected as drastically as stock prices are. Supply and demand does affect them somewhat, but not nearly as much as it affects stock prices. Bond prices are mostly calculated based upon the present value of future cash flows that are guaranteed by the bond issuer - which depends upon the interest rate, time to maturity, and the credit rating of the bond. So, while most people believe that when stocks fall, bonds rise... this is almost true. It is more likely that when stock prices fall... bond prices fall somewhat less... but pay more yield... because pension funds are selling stocks and buying the bonds they see as cheap at that particular moment in time.

Accordingly, the market movements we are seeing today appear to be mostly a result of institutions shifting money from one asset class to another - portions of their portfolios from stocks to bonds - to provide greater certainty within the portfolios. Any "panic" associated with this market drop is likely on the part of mom and pop investors or market timers... or entirely made up by the media to grab some screen time from you.

As of this writing, the S&P500 is up about 11% for the year - even with the price decline over the last week or so. That's still pretty good - and historically, midterm elections are good for stocks 70% of the time, with a good bit of the gains rolling in after the election, once certainty is known. Strangely enough - one of the best things for the market is... gridlock... since betting on drama and ultimately, inaction, inside the beltway, makes financial decisions easier for investors than a government that may change things - and provide uncertainty.

Also, currently, the economic data is still very, very strong. While we do have a flattening yield curve, which signals that we are likely in the last 2 innings of the expansion phase of this business cycle... and arguably stocks are a bit expensive compared to 2 years ago, there currently is no data which suggests that a recession is imminent. Should that change, of course, we will begin preparing for Recession Protocol and keep everyone informed.

So, we suggest patience. Of course, election season is now upon us and it will be virtually impossible to watch TV or get on the internet at all without having political mudslinging ads in our faces... so we'll be exercising our patience anyway. Hopefully it will be over in a few weeks and we will see the markets return to their upward trend.

UncategorizedJon Castle