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October 2018 Retraction

by in Trusted Advice

At the end of September, most major stock market indexes stood at all-time highs. The economy was booming and interest rates, while rising, still remained low by historical standards. Although the economic fundamentals have remained largely unchanged, merely one-month later much has changed in the stock market. The S&P 500 has dropped by nearly 10% this month and, after leading the market higher for the past two years, Nasdaq stocks have taken a beating in October, closing down nearly 15% this month. This performance is the worst of any month since the financial crisis began ten-years ago.

So what has led to the precipitous drop and what lies ahead? The most often cited reason for the correction is the rapid rise in interest rates as represented by the ten-year U.S. Treasury Note. On September 6, the yield on this Note was 2.88%. By October 1, the yield had risen to 3.08% and by October 10 to 3.23%. After the Fed raised the fed funds rate at the end of September, Fed Chairman Jerome Powell made comments that were perceived by investors as overtly hawkish when he stated that the Fed believes there is a lot more room to continue raising rates.

10 Year T Note 10 30 18

Third quarter earnings reports have awakened investors to the potential impact of increased tariffs on the cost of goods, profit margins and the competitive environment for some multi-national companies. Fear of an escalation in the trade war with China has further roiled markets in recent days.

As we have learned from previous sharp, sudden corrections in the past several years, computer-driven trading programs have exacerbated the declines in the market. Traders and many money managers use of ETFs coupled with algorithmic trading programs has also driven stocks sharply lower.

VIX 10 30 18

The turmoil in stocks has ironically triggered a flight to safety dropping the yield on the 10-year Treasury Note back to 3.08%. With third quarter GDP growth reported at 3.5% it is clear the U.S. economy remains strong. However, growth forecasts for the rest of the world have recently been cut due to slowdowns in China, Europe and many emerging markets. In addition, rising U.S. rates have hurt the domestic housing and auto sectors in recent months.

In our view, the market has very quickly gone from overbought at the end of September to oversold at the end of October. The recent correction has created some interesting buying opportunities for investors. The economy and corporate earnings remain strong. Inflation and interest rates, while on the rise, are still historically low and valuations are now more reasonable. While it is impossible to know when corrections fully run their course, it would not be surprising to see an attempted rally in the days and weeks ahead, as the typical market correction only lasts about four months. A moderation in the tone on interest rates from Fed officials and/or constructive comments from U.S. or Chinese trade representatives would create some of the conditions helpful to trigger a rally. In any event, after a sudden correction, it is rarely a good idea to panic. Should you wish more perspective, we urge you to consult your Covenant financial advisor for more elaboration on October’s correction.

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Guest Sunday, 23 February 2020