Don’t Call it a Crash (Yet)

The S&P 500 index fell nearly four percent intraday on Monday, January 24, making for one of its most volatile trading sessions since September 2020.  Heading into this period of instability, investors had good reason to believe that the markets were heading for a collapse.  Rising inflation, concerns about the Omicron variant, the potential for war with Russia, and a Fed poised to aggressively raise interest rates amidst a clouded U.S. and global economic outlook had seemingly overshadowed any positive catalysts for an upward market move. 

S&P 500 Index Intraday Declines Greater than 3%

With so much uncertainty on the rise, and policymakers poised to drain liquidity from the financial markets, a key question for many investors is whether we are on the precipice of a prolonged market selloff.  Certainly, some market watchers and prognosticators are making the rounds on financial media and arguing that this week’s volatility is setting the stage for lower equity prices ahead. 

Anecdotes aside, historical data indeed suggests that a period of market weakness in risk assets is likely on the horizon after this week’s moves.  That said, however, there’s still a case to be made for avoiding panic and remaining committed to a long-term investment strategy amidst solid economic and corporate fundamentals.  Indeed, it’s during these times of increased market uncertainty that financial independence masters like yourself preserve their wealth by adhering to their disciplined asset accumulation and retirement distribution strategies.

Intraday Decline and Future Market Performance

So, what should we make about Monday’s market decline?  Well, one way to interpret the selloff is to view the market move in a historical context.  To do this, we looked at S&P 500 index data going back to 1982 first to understand the frequency and significance of sharp intraday pullbacks.  Second, we evaluated how stocks have performed in the periods following a significant one-day selloff. 

What did the data show?

Well, to the first point, history shows that days where the markets declined by at least 3% intraday, like the one we saw this week, have occurred in less than two hundred of the ten thousand trading days over the past forty years, or 2% in total.  In fact, the data show that, on average, stocks tended to decline less than one percent in intraday trading over this period.  Moreover, our analysis suggests that these sorts of pullbacks are prevalent heading into periods of price weakness, more so when market narratives change. 

So, now that we know that what happened this week wasn’t just another run of the mill market slump, what does history tell us about how stocks have performed in the weeks and months following such a selloff?  Historically speaking, the data suggests that markets more often than not continued sliding an average 8% in the month following a sharp one-day selloff. 

And how have stocks performed after three months following a selloff greater than 3%?  Well, from this expanded timeline, the data fares somewhat better, with markets down only about a third of the time.  And finally, if we look out over a one-year horizon the data suggest that equity prices are down about a quarter of the time over the past four decades.  Taken together, one way to interpret Monday’s selloff from a historical context is that volatility likely could remain elevated in the near term, with market conditions improving over the long term.

Is it a Crash or Market Correction?

While there’s certainly precedent for continued market weakness in the weeks ahead, a key question for some investors is whether we’re heading for a market correction or a market crash.  First, it’s important to clarify that a crash is much different from a correction.  A market crash can be characterized as a sudden, steep decline occurring over a matter of days.  For example, you’ll likely recall that in February 2020, the S&P 500 index declined over 10% in less than a week amidst Covid concerns before dropping the following month precipitously. 

On the other hand, Corrections generally extend over weeks and are relatively common.  So common, in fact, that corrections have occurred 18 times over the past decade.  So, what does all this mean?  Well, as we pointed out earlier, while a sharp intraday pullback has been historically consistent with near-term risk asset declines, several catalysts like expectations for positive economic growth and rising corporate earnings this year likely remain supportive of equity prices.

S&P 500 Index Analyst Earnings Estimates

Solid Fundamentals as Tailwinds Fade

Indeed, compared to the outlook driving the market crash of 2020, economic fundamentals today are softening yet remain generally on firmer footing.  For example, the government this week reported that U.S. economic growth bested expectations in the fourth quarter and that the economy expanded at its fastest clip in nearly four decades on an inflation-adjusted basis.  Data also show that personal income and household balance sheets remain solid as the unemployment rate declines and employers offer higher wages to their workers. 

From a business sentiment perspective, the Richmond Fed’s latest survey of CFOs shows that optimism among business leaders remained buoyant in the fourth quarter of 2021.  Indeed, aside from cost pressures and supply chain issues (which we’ll discuss in a moment), positive hiring intentions remain a key indicator of forward-looking business health.

On the earnings front, analysts expect corporate earnings growth to slow compared to last year’s post-pandemic rise, but generally are anticipated to remain positive in 2022.  This data is vital because heading into the market crash of 2020, corporate CEOs slashed forward guidance, and earnings declined amidst policy-induced economic lockdown measures. 

US Average Hourly Earnings

Self-Inflicted Wound

While backward-looking data suggests that the U.S. economy has been on solid footing, forward-looking indicators point to both economic and market headwinds in the months ahead.  Top of mind for households, businesses, policymakers and market participants alike is the persistence of stubbornly high inflation.  This concern is evidenced in headline inflation coming in at 7.1% in December, its sharpest rise in forty years.  At the same time, the core PCE index (the Fed’s preferred measure of inflation) came in at 4.9% in December, compared to a pre-pandemic average of 1.6%.

This inflation rise has also been evident in record-high home and auto prices as well as the rising cost of food and gasoline, which understandably has households worrying.  Indeed, data out on Friday from the University of Michigan showed that consumer sentiment is at among its lowest level since the start of the pandemic, with survey respondents reporting five-year inflation expectations at their highest level in a decade.  At the same time, business surveys indicate that rising input costs are among the top concerns for business leaders.

To address seemingly out of control price increases, Federal Reserve policymakers have announced measures to quickly raise interest rates and have scaled back asset purchases.  And it’s this aggressive policy response that has caught market participants on the back foot and contributed to recent bouts of market volatility.  As it stands, the Fed is ready to raise rates four times this year (likely beginning in March), with some analysts predicting as many as seven hikes this year. 

While monetary policy can be used as a tool to slow rising prices, a slowdown in the economy (or even worse, a recession) could result as a self-inflicted wound via Fed policy in 2022, which has some market participants on edge.  The reason being is that today’s spiraling inflation is in many ways driven by logistics issues over which the Fed has little control. 

To be sure, at a macro level, global supply chain issues have contributed to the rising prices of everything from clothing to autos.  At a local level, a report from the American Trucking Association suggests that the U.S. is experiencing a shortage of around 80,000 drivers due to illness, retirement, or simply a lack of interest.  This shortage of freight delivery drivers and the rising cost of transportation is putting upward pressure on the price of goods on store shelves – something the Fed can’t control.

Freight Costs Growing Fastest in Decades

Don’t Call it a Crash (Yet)

While there’s a reason for concern among some market participants, it may yet be too soon to call recent market moves the beginning of an outright crash.  Indeed, compared to the events of the market crash in 2020, both fiscal and monetary policymakers have greater leeway on addressing impediments to economic growth, which can affect market sentiment. 

Nevertheless, with forward-looking indicators pointing to signs of slowing economic growth, market participants need some clarity that aggressive Fed policy won’t choke off economic growth and, hence, corporate earnings.  Simply put, how the Fed threads the needle of policy tightening while preserving economic growth will determine whether the markets can claw back gains or succumb to a prolonged bear market selloff.  This is one reason why incoming forward-looking economic data will be crucial to market sentiment in the coming weeks, confirming whether or not the economy can handle higher rates.

So what’s an investor to do during these times of changing market narratives and policy uncertainty?

Whether you’re still saving up for your early retirement goals or have already become financially independent, now is the time to carefully consider your investing, savings, and spending strategies for the coming year.

Saving for Financial Independence

If you’re still in the accumulation phase of your financial independence journey, now’s likely an excellent time to take a second look at how much you’ll need to have saved to cover your post-employment lifestyle expenses in the future. 

While it’s likely that the inflation rate could slow in the months ahead, the truth is that prices of goods and services will potentially remain elevated for years to come.  Indeed, the rapid rise in home, auto, and other consumer goods has reset long-term baseline spending needs for some individuals.

From this perspective, your role as an asset accumulator will be to ensure that the baseline financial independence savings goal you’ve defined for yourself five, ten, or twenty years down the road are consistent with the reality of higher prices today.  From there, you’ll need to determine if and to what degree your savings needs to increase today to meet your new financial independence number.

Additionally, during these times of uncertainty, you’ll likely want to avoid the temptation to shift your investment strategy when markets become volatile.

Unless you have a near-term need to drawdown investment savings, changing your asset allocation, like going to all cash, could be detrimental to your long-term savings plan.  Indeed, as we pointed out in a prior report, missing even the ten best days in the market could leave your long-term financial plan falling short.

Missing the Best Days in the Markets

Preserving Your Financial Independence

If you’re already financially independent and living off of your savings, being prepared for a bout of market volatility while accounting for higher prices in the years ahead likely will be essential to preserving your wealth.  No one has a crystal ball to tell them where the economy or markets are headed.  That’s why during times of uncertainty, your investment process is vital to ensuring long-term financial success.  To this end, we suggest that you take a multi-pronged approach to ensure that your assets are well-positioned to provide savings longevity.

First, as with the accumulators, take the time to reevaluate your long-term income distribution need when factoring in higher levels of inflation and market volatility using Monte Carlo simulations.  After completing this analysis, you may find that your financial wealth could fall short of your high-confidence savings projections.  If this is the case, now may be the time to adjust your near-term lifestyle spending trends by making minor adjustments to expenses, which can significantly impact your overall savings need.

Second, stay committed to a disciplined investment process.  Periods of market uncertainty, like we experienced this week, might tempt you to go to cash in anticipation of a broader market selloff.  On the other hand, after reevaluating your savings need, you may be tempted to increase your investment risk exposure to make up for a projected savings shortfall.  Either way, when it comes to managing your wealth, focus on what you can control and stay committed to long-term outcomes.

Finally, ensure that you have enough cash on hand in the coming months to navigate periods of market uncertainty.  The last thing that you’ll want to do is sell portfolio holdings to pay for household expenses when markets are in decline.  Selling at inopportune times may lead to disappointment and reduce your likelihood of long-term retirement success, particularly if you’re not in a position to add to savings through employment income.

While we may not be headed for a market crash just yet, there’s ample fuel for a prolonged market selloff in the weeks ahead.  With that said, however, there’s still a case to be made for avoiding panic and remaining committed to a long-term investment strategy amidst solid economic and corporate fundamentals.  Indeed, it’s during these times of increased market uncertainty that financial independence masters like yourself preserve their wealth by adhering to their disciplined asset accumulation and retirement distribution strategies.