The past few months have been less than kind for stocks, but December has been outright awful. As with any newsworthy selloff, the pundits have been attributing this to a whole host of reasons. With all the volatility and bad news, it’s easy to get overwhelmed trying to decipher the reasoning behind this drop in the market.
There has certainly been no shortage of concerns to justify the daily swings we’ve seen in the stock market; news of a trade war, slowing global GDP and the partial government shutdown just to name a few. But we think the real underlying issue facing the markets are rising interest rates and next year’s plans by the Federal Reserve.
We’ve lived in an easy money economy ever since the financial crisis almost ten years ago. Worldwide, central banks have flooded the globe with cash in order to stimulate their economies as well as prop up asset prices (primarily home prices). The stock market has benefited greatly from those efforts over the last seven or eight years. The low interest rates have also benefited the bond market, keeping bond prices higher than the market would otherwise allow.
These interventions came in the form of two actions. First, the Federal Reserve had set the Fed Funds rate (the one rate they have direct control over) to near zero for many years and only began to gradually raise them over the last couple of years. The market was willing to ignore those recent increases because they were coming off incredibly low levels. The second and more interesting action the Fed took was to step into the secondary bond market and purchase mortgage-backed securities in massive amounts. In effect, they were competing for the very same bonds that private investors were buying. The competition drove down longer-term rates and have held them there.
These two interventions have put the Fed in a difficult position. Should the economy hit another rough patch, or another crisis arise, the Fed has nothing left in their tool box to intervene with. Furthermore, the extended length of time these policies have been in place runs the risk of creating another bubble in the financial markets. For these reasons, the Fed has desperately wanted to unwind these policies. Thus, we have the rate increases and other policy announcements that the markets are worried about.
There is certainly no surprise as to what the Fed is trying to do. It’s just that now there is increasing concern regarding economic growth. These concerns are mostly related to Europe (Brexit being the leading issue there) and Asia (tariffs and trade wars), but the markets believe those troubles could spill over to the U.S. In light of these events, the markets are worried that the continued tightening will lead us into a recession. The Fed clearly thinks otherwise and has announced that they plan on staying the course and to continue tightening in 2019 and 2020.
The resulting selloff in stocks has been dramatic. We’ve essentially seen the market gains from late summer turn into losses. The small cap sector, which had been the leading index, was up 15% at the end of August. That index is now down 14%. Similarly, the S&P 500 was up 8% in September and is now down 11%. These declines now seem to be feeding off of themselves. Every little daily event seems to give us another 400-point day on the Dow.
So what does this really mean to stock investors in 2019? Is this something to worry about or a buying opportunity? Our guess is that looking back this will have been a buying opportunity. The reason we say this is that all of the big daily swings have been driven by some piece of news and not actual data. The data suggests the U.S. economy is still very strong. GDP, and employment, consumer confidence are all strong. Oil prices are falling which will be a widespread benefit to industry. But most importantly, the Fed has the ability to put the brakes on all of their plans should the economy actually turn south. Based on what we’ve seen, we think stocks would reclaim all of these losses if the Fed were to announce they’re putting all their plans on hold. This in fact is what the President is arguing for and he may have a valid point. One worry about the Fed is that they’ve historically been too slow to react in these situations.
In the meantime, we think it’s best to sit tight and let this run its course.