Uncertainty has crept into the stock market over the past few weeks just as the market's health improved. We've been waiting for the number of stocks participating in the gains to broaden, which occurred briefly after the July inflation report.
The question before this report was how long interest rates would remain elevated. This concern weighed on all but the largest companies immune to higher rates. However, the July report showed inflation was lower than expected, hinting that interest rates might drop sooner. Now, we need to understand why inflation fell more than anticipated. It could be because more people are losing jobs or because they've run out of savings and maxed out their credit. Either situation could lead to a recession.
Below is a table from my January letter. It outlines how stocks and bonds might react to changes in interest rates.
The market rallied at the end of 2023 and throughout the first months of 2024 based on the expectation that interest rates would decrease because inflation was declining and we would avoid economic pain. This view that rates would come down for good reasons was very optimistic. Fewer jobs than expected were added on Friday, and stocks fell. The market now worries that interest rates are dropping for the wrong reasons, possibly a recession and higher unemployment.
I stated the following in last month's letter:
…Despite this, the S&P 500 had a solid start to the year, with its eleventh-best first quarter since World War II. However, like in previous strong starts, we experienced a pullback, losing 5.5% in the first half of April. Historically, a second decline often follows the first. On average, this second drop is around 12%, which would bring the S&P 500 down to 4,800.
From a historical point of view, we could expect a downturn before year-end, but it wasn't guaranteed. When I saw more stocks participating in gains, I updated my recommendations accordingly. My optimistic outlook remains despite the recent dip.
There are two types of market downturns. The 2022 bear market was preceded by months of deterioration, beginning in the Fall of 2021. The other type is the drawdown we experienced during the COVID-19 pandemic. When I left the office on February 19th, 2020, I had no concerns about the stock market's health. The next day, the COVID caught the market's attention, and the selling began. Both types of downturns can be worrisome, but each should be dealt with differently.
I made moves for clients in the second half of 2021 and throughout the first months of 2022 because I saw signs of the market running out of steam. However, I did not catch the pandemic downturn; no warning signs existed. I was on the phone all day, trying to calm everyone's nerves, although I didn't believe we were in for a significant drawdown. I had this conviction because of how it started. Markets don't usually change overnight; the pandemic caused sudden uncertainty, leading to a significant but short-lived sell-off. Eventually, uncertainty clears, and markets recover. With increased uncertainty now, investors are reacting predictably.
I have a cartoon in our conference room showing a man sitting in a doctor's office, telling him, "It only hurts when the market is open." These past few years have been among the most difficult to navigate since I began my career. I rely on what has already happened in the stock market to guide our outlook. This helps keep emotion out of managing money, but it is not a crystal ball.
There will always be something to worry about, and 2024 is no different.