Perspectives on the Recent Market Sell-Off

To paraphrase Ernest Hemingway, shifts in the stock market often occur “gradually, then suddenly.” Over the past month, the market has rotated from large cap technology stocks to small caps and other sectors. Following the latest jobs report, however, global stocks experienced a sharp pullback due to concerns over the timing of Fed rate cuts, a weakening labor market, and disappointing tech earnings. Financial markets are on edge as investors adjust to a changing economic landscape.

Specifically, the Nasdaq is now in correction territory, defined as a 10% decline from recent highs. The S&P 500 has pulled back 5.7% from its high three weeks earlier, while the Dow has been steadier with a decline of 3.5%. The VIX, often described as the market’s “fear gauge,” has surged to its highest level since early 2023. The 10-year Treasury yield has now fallen below 3.8%, a sharp decline from 4.7% only three months ago.

Ironically, current macroeconomic conditions – inflation returning to 2%, low but rising unemployment, falling interest rates, and double-digit stock market gains – are exactly what investors had hoped for at the start of the year. But here we are with a steep selloff nonetheless.

As an investor, what is going on and what should you be considering at this moment?

What is causing the recent selloff?

Investors and economists are now concerned that the Federal Reserve may have made a policy mistake by waiting too long to begin cutting rates. The Fed has now kept rates unchanged for over a year as it seeks “greater confidence” that inflation is returning to its 2% target. However, its focus on inflation is now resulting in a weakening labor market, which some fear could move the US toward a “hard landing.”

It’s important to remember how fickle market expectations have been. The year began with investors believing the Fed would need to cut rates several times due to an imminent recession. Expectations then shifted after a few hotter-than-expected inflation reports, with investors believing the Fed would not cut at all this year. Today, markets expect the Fed to cut in September and possibly at each subsequent meeting. These swings show how difficult it is to get monetary policy right, even as backseat drivers.

These dynamics have shifted the Fed’s focus to the labor market, with the Fed acknowledging that it is “attentive to the risks to both sides of its dual mandate.” The latest jobs report showed that the economy added 114,000 new jobs in July, lower than the consensus estimate of 175,000. Unemployment, which was expected to remain at 4.1%, rose to 4.3%. While this is still relatively low compared to history, it is the highest rate of unemployment we’ve seen since the pandemic (and mid-2017 before that).

Related to this increase in unemployment, economists are concerned because a lesser-known recession indicator, known as the Sahm rule, was triggered recently by the July jobs report. The Sahm rule, named after a former Fed economist, predicts the onset of recessions based on the trend in unemployment. The simple intuition is that a sudden jump in the unemployment rate is highly correlated with economic downturns. In fact, the very definition of a recession depends on the state of the job market.

However, it’s important to keep in mind that immigration and higher labor force participation were key drivers in rising unemployment. Additionally, Sahm herself recently stated that this is more of a “historical regularity” and not a hard-and-fast physical law. In other words, with unemployment still near historic lows, a rise in unemployment to 4.3% should be watched carefully but does not necessarily mean a recession is imminent.

Fundamentals remain solid and provide a robust foundation looking ahead

Despite the recent market volatility, the fundamentals of our economy remain strong. As shown in the accompanying chart above, the US economy grew at a 2.8% pace in the 2nd quarter, which was much higher than expected. According to the BEA and Census Bureau, personal spending and and retail sales remain positive and steady for the year. Job growth has also remained steady overall with the BLS showing that total nonfarm payrolls are up nearly 1% for the year. Additionally, corporate earnings have remained solid. According to FactSet, the blended (year-over-year) earnings growth rate for the S&P 500 is 11.5% for the 2nd quarter, which would mark the highest year-over-year earnings growth rate reported by the index since the 4th quarter of 2021. Profit forecasts are still positive as well, with S&P 500 earnings expected to grow 13% over the next 12 months. More than half of S&P 500 sectors are expected to grow earnings by double digits, and all 11 sectors are forecasted to experience positive growth. In the long run, earnings are what drive stock market returns, and thus the health of the economy matters more than short-term stock and sector-specific trading activity.

Overall, these data points, among others, provide further evidence that a recession is not imminent and provides a strong foundation for when the Fed decides to start cutting interest rates in the near future.

Powell & the Fed to the rescue?

During the recent Fed meeting, Chair Powell stated “a rate cut could be on the table in the September meeting.” He also stated they are “getting closer to the point at which it’ll be appropriate to reduce our policy rate.” The market was already predicting a rate cut in September and potentially one more by year-end. However, with the recent data showing signs of slowing employment as well as less than stellar earnings from several companies, many are now pricing in as many as 5 rate cuts before year-end. In fact, some are even calling for an emergency rate cut, such as renowned economist from Wharton, Jeremy Siegel, who believes the Fed should make a cut very soon and suggested that the “fed funds rate right now should be somewhere between 3.5% and 4%.” If and when the Fed cuts rates, this should bode well for not only the stock market but also the bond market, where rates and bonds prices/values move in opposite directions.

Perspective is very important in volatile markets

Investors focused on recent performance alone would no doubt wonder if the cycle is over. While recent market events are still playing out, it’s important to remember that not only are stock market swings normal, but they can also be healthy if they are the result of investors adjusting to new economic facts. This is especially true if valuations improve as prices adjust and corporate earnings continue to grow.

The accompany two charts below provide further evidence of how normal pullbacks are and why it is important to maintain a long-term perspective:

1.) For many investors, the volatility since 2020 may already seem like a distant memory after the steady recovery of the past year and a half. As the first accompanying chart shows, the S&P 500 has gained 113% over the past five years, including the pandemic collapse and the 2022 bear market. While market pullbacks are never pleasant, viewing the market on these timescales does help to put the current decline in perspective.

2.) The second accompanying chart shows how common and frequent intra-year declines have been historically. Declines of 10% have happened nearly 60% of the time since the late 1980s, while declines of at least 5% have occurred nearly every year. The average decline has been about 14-15% per year. However, despite these pullbacks, stocks ended the year in positive territory over 80% of the time.

Investing is about both returns and managing risk

Investing is never a simple, smooth ride. In the classic book “A Random Walk Down Wall Street,” author Burton Malkiel writes that “the stock market is like a gambling casino where the odds are rigged in favor of the players.” Investing in the stock market comes with many risks that can be managed with proper portfolio construction and a long time horizon. History shows that despite the ups and downs of the market, staying invested and well-diversified is still the best way to grow wealth and achieve financial goals over the course of decades.

Stocks never move up in a straight line, so how we react to market volatility is perhaps more important than the volatility itself. The S&P 500 has now experienced its second 5% or worse pullback this year. As the accompanying chart shows, this is below the average of 4 to 5 pullbacks experienced in the average year, and the dozens during bear markets.

Additionally, current market concerns driven by tech stocks, the Fed, and the labor market all have their silver linings. The economy is still quite healthy, corporate earnings are still growing, and if interest rates do sustainably fall, many other parts of the market (both stocks AND bonds included) could benefit. As in past episodes of volatility, seeing past the current market moves and headlines is needed to benefit from the long-term trend.

 

The bottom line? Recent economic data have sparked concerns that the Fed should have cut rates sooner. Tech stocks have also declined as investors worry about valuations and earnings. However, solid economic fundamentals, corporate earnings, and the likelihood of Fed rate cuts sooner rather than later should provide a boost of optimist in the short-term. But overall, in volatile markets, it’s important for to stay level-headed, disciplined, and well-diversified with a focus on long-term goals.