A Devilish Day in the Market
Today (2/2/2018), the Dow suffered its largest single-session point plunge since 2008, losing 666 points. Expressing the decline in percentage terms (2.54%) puts it at about a quarter of what we saw during the darkest days of 2008. However, even this muted level feels uncomfortable because we have become so accustomed to incredibly low volatility over the past few years, and lately, we have only seen volatility in the upward direction.
To put things in perspective, on a year-to-date basis, the Dow is up 3.24% and the broader S&P 500 Index is up 3.31%. If, by some accident of the calendar, January had ended today rather than two days ago, we could still argue that the “January Effect” was in full gear, as both indexes are well on their way to capturing a full year’s worth of expected returns.
As we discussed towards the end of 2017 regarding Vanguard’s long-term market outlook, the primary threat to both stocks and bonds is unexpected inflation deriving from tight labor markets. The primary driver of today’s decline (along with an increase in the 10-year Treasury bond yield to a 4-year high of 2.84%) was the most recent Jobs Report showing a 2.9% increase in hourly wages for January and 200,000 additional nonfarm payroll jobs, 20,000 more than consensus expectations. With the unemployment rate of 4.1%, the economy appears to now be at full employment.
Naturally, the concern of the bond market is that the Fed will increase interest rates beyond what is currently planned. According to Martin Feldstein, lower bond prices may make them more attractive relative to stocks, leading to further declines in the stock market. In addition to inflation, we now have the prospect of higher issuance of Treasury bonds to meet rising deficits, as discussed in today’s Wall Street Journal article, “Deficits Shake Up Treasury Bond Issuance.” As the authors summarized it, “Treasury yields are rising, some investors think, in part because the supply of government bonds hitting financial markets is rising as budget deficits grow as a result of the Trump administration’s recent $1.5 trillion tax cut.” The borrowing estimate for the current fiscal year ending 9/30 is $955 billion, almost double the $519 billion for the prior year. Estimates for 2019 and 2020 are both around $1.1 trillion. As much as we like tax cuts, they do have consequences, and as with all things financial, there are no free lunches!
One other WSJ article worth discussing is “Retail Investors Jump Into Market” (1/27/2018). The author begins, “After sitting out most of the nearly nine-year bull market, individual investors are finally pouring in…some of them lured by the boom in cryptocurrency and cannabis investments.” This, of course, is a classic indicator of the end of a bull market or the bursting of a bubble. We hope this is not the case here.
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