Dow drops: Are you ready for the stock market roller coaster?

Stocks markets took a break from their meteoric rise of the last several months. The Dow dropped 2.5%, and the S&P 500 fell 2.1% on Friday, capping their biggest weekly decline in more than two years.

Although frustrating to some, today’s losses are likely a good thing. The market was in need of a pullback. Week after week of positive results, while comforting to hear, is not how markets normally behave. Overheating was a concern on the minds of many market participants. A down week helps to tamp down the flames.

Friday’s pullback was not really surprising given the extreme upsurge we’ve seen in equity prices. Moves of 2-3% are not unusual in hot markets, especially a late-stage bull market like the one we’re in. Investors need to be prepared for volatility in 2018.

Setting the scene
Today’s selloff followed news that the economy had added 200,000 jobs in January and wages grew at the fastest pace in eight years. Investors might be worried that wage growth could impact corporate profits, one of many examples in which the interests of asset owners and labor are not perfectly aligned.

But both groups should be concerned about inflation, which is rising now that a $1.5 trillion tax bill has begun to work its way into paychecks and wages are increasing.

If inflation heats up, the Federal Reserve could step in to raise interest rates more than expected this year. Forecasts currently call for three hikes in 2018, but fears abound that higher rates could choke off borrowing, which could dampen economic activity. Bond markets reflect worries over inflation, with the yield on the 10-year Treasury hitting a four-year high of 2.84% on Friday. As yields rise, bonds could begin to look more attractive to stock investors, triggering more stock market volatility.

FOMO can be a pain
Investor fear of missing out on market gains also contributes to the uncertainty. Cash has poured into equities recently, with another $25.7 billion finding its way into stock funds in the last week of January.

The portfolio manager of the Azzad Ethical Fund, Christian Greiner, CFA®, talked about this in his 2018 market outlook, saying “bull markets usually end with a crescendo – with a spike in levels and valuations, as the market captures the public interest, and everyone feels the need to be in the market. We could see higher earnings estimates lead to higher multiples as the market approaches its cyclical peak, hitting new highs. This is known as a “melt-up.”

A melt-up rally can be caused when a market’s gains are noticed and finally capture the public’s imagination, Greiner says. “People feel the need to get into the market, chasing prior gains. The increased investment flows often drive up prices and price-to-earnings multiples, leading to the exuberance we associate with market tops.”

The graphic below shows the Association of American Individual Investors Bull Ratio – a common measure of market sentiment, measuring the percentage of investors who are bullish on the US stock market. The higher the number, the more optimistic investors are about stocks. Since hitting a post-crisis low before the election, it has spiked to post-crisis highs, near 60%. For contrarian investors, this is a warning sign.

Does this mean the bull market is over? No. Corporate earnings, a major driver of long-term stock returns, are still strong. With a few notable exceptions, most companies at this point in the season have reported better-than-expected earnings. And as evidenced by employment numbers, the economy is still humming along.

But as this bull market starts to move up the record books in terms of length (but not necessarily potency), let’s remember how the market traditionally behaves late in the cycle.

Late in the cycle, investors are concerned about inflation and rising interest rates, and look to protect their portfolios against the effects of these two forces. Commodities might start to perk up, and the companies whose fortunes are tied to them might see a pick-up.

With that in mind, investors tend to move away from utilities, which are traditionally interest-rate sensitive. Instead, they gravitate towards technology and industrial stocks, which may benefit from the increased capital spending that happens when companies are flush with cash. They also try to gain exposure to cyclically sensitive energy and materials stocks.

Bottom line
Volatility, a force that had lain dormant for many months, appears to be back. Make sure your asset allocation is in line with your risk tolerance and time horizon. If you’d like to reassess your risk tolerance due to a recent life change give your advisor a call.