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Cam’s Corner: Dealing with Market Corrections and Volatility

Welcome to the 3rd installation of the Wake Forest Review’s finance column: Cam’s Corner. This column will be a place where I offer anything from general thoughts on financial markets and economic trends to individual stock picks. It is designed to be a useful source of ideas for young adults beginning to invest for the first time and seasoned investors alike.

 I will write this column weekly to be released on Monday mornings, so readers will be prepared before markets open each week. Furthermore, I would like readers to engage with me in the comment section by offering anything from opposing viewpoints to reaffirming ideas. This subsequent discussion will only improve the quality and usefulness of this column.

 Correction Territory

U.S. equities suffered more losses last week with the Dow Jones, S&P 500, and NASDAQ falling 5.21%, 5.16%, and 5.06%. The Dow Jones and S&P 500 dropped more than 3% on Thursday, which briefly pushed both into correction territory. A market correction is typically defined as a fall of more than 10% from highs within two weeks. Last Thursday marked the fifth correction U.S. stock indexes experienced since the current bull market began. The correction was primarily caused by fears of rising inflation and subsequent interest rate hikes.

Volatility

 Last week also featured significantly increased volatility, as the Dow Jones swung at least 1,000 points every day except Wednesday and changed direction 53 times. The CBOE Volatility Index (VIX) closed Tuesday at its highest level since August 2015, then closed Friday nearly 70% higher than it started the week. Many investors expect increased volatility to persist this week, as confusion remains as to where the selloff will cease. If your investing horizons are long-term and you don’t attempt timing the market, you should perhaps turn off CNBC and your smartphone’s updates. However, you may want to liquify some of your equity investments if you have a high-risk aversion and lose sleep when your portfolio takes a hit.

Broad Selloff

I considered shifting some of my portfolio from U.S. equities to international equities last week. The selloff made me nervous, and I told myself that valuations were more attractive outside the U.S., blah blah blah. That act, however, likely would have been futile, because the correction was broad in nature with the selloff transcending both sector and region. For instance, last week all eleven sectors of the U.S. stock market suffered losses, and indexes in Europe and Asia also fell into correction territory. This serves as a sobering reminder that often diversification doesn’t protect investors when things go south. The best option here may just be to maintain the proportions in your portfolio designated to domestic and international equities.

What’s Next?

 Will the selloff continue and push the stock market even lower? Or, has the stock market already handled the correction and positioned itself to extend the current bull market? The answer to these questions revolves largely around how investors interpret the developing narratives of strong economic growth and corporate earnings versus signs of rising inflation and subsequent interest rate hikes. On that note, investors should continue to monitor gross domestic product (GDP) growth, fourth-quarter earnings announcements, jobs reports/further wage growth, and Fed meetings/interest rate hikes.

Above is a chart from the CME’s FedWatch Tool, which shows the probabilities of what the federal fund’s target rate will be after the Fed’s December 2018 meeting. The target rate is currently 125-150 basis points, and there are 30.9% and 13.7% chances of three and four rate hikes of 25 basis points in 2018. However, these probabilities [perhaps strangely] are down from 35.5% and 21.1% on Friday, February 2nd when the January jobs report showed the largest year-over-year wage growth since June 2009. I will be monitoring the CME’s FedWatch Tool closely moving forward, as monthly jobs reports continue to be released and expectations regarding inflation continue to change. Increasing probabilities of 3+ rate hikes would make me nervous. Higher rates increase the cost of borrowing and typically stymie economic activity.

 Going Forward

Many investors and analysts were/are suggesting to buy the dip. This is a sound investing strategy, and it should be considered if you believe strong economic growth and corporate earnings will continue to push the stock market higher. However, strong economic growth and corporate earnings don’t necessarily guarantee a strong stock market. In an article with The Wall Street Journal, chief European investment strategist at BCA Research Dhaval Joshi said, ‘During the last three downturns, the causality ran from financial markets into the economy, not the other way around.’ This idea, in short, is that investor sentiment–not fundamentals–can trigger the beginning of a decline. In fact, investors withdrew $22.9 billion from U.S. stock mutual funds and exchange-traded funds during the first week of February, according to fund tracker EPFR Global.

I am nervous that changing investor sentiment stemming from the length of this bull market, signs of rising inflation, and high valuations may override strong economic growth and corporate earnings. And out of principle, I usually refrain from attempting to time the market. I have therefore decided to do absolutely nothing with my portfolio, then invest more once the stock market falls more and valuations are more attractive.

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