This blog is a reprint of a communication sent to our clients on October 12, 2018 that shared our best thinking about the market volatility seen during that week and to calm fears by putting those volatility numbers into historical perspective.
The Law of Large Numbers - Stay the Course
The most frequently watched stock market index, the Dow Jones Industrial Average, sold off 832 points on Wednesday and was down another 546 points on Thursday for a two-day drop of 1378 or 5%. Like clockwork, the financial news media rolled out many investment commentators with dire warnings of more problems ahead. Most are pointing to Federal Reserve Chairman Jerome Powell and his stated aggressive path for short-term interest rate hikes as the culprit. Despite the bearish predictions, we believe the powerful economic forces driving the U.S. economy combined with historically low unemployment and consumer optimism will likely lead to increased profitability for U.S. companies and better markets ahead.
In 1980, a single-day 832-point drop would have represented a 100% loss for the index! Today, while the large numbers representing the Dow Jones Industrial Average daily price changes are eye-catching and make headlines, they are generally modest in percentage terms as we see with 832 points representing only a 3% move in the index. Should you even worry about the daily price moves in the Dow Jones Industrial Average? Probably not. Consider that the Dow Jones is just 30 companies selected to represent the U.S. economy and the index is price-weighted, essentially weighting the index towards higher priced stocks. For example, Boeing is the largest holding in the Dow, representing 9.73% of the index thanks to its $363 stock price, compared to a weighting of 0.83% in the more broadly diversified S&P 500.
The S&P 500 Index (which also lost 5% over the past two trading sessions) is a better representation of the overall U.S. stock market as it is not dependent on the prospects of a small number of companies. Historically, on average, the S&P 500 moves up or down one percent 62 times per year, or 24% of all trading days. In a market full of buyers and sellers who trade on emotion (fear and greed), it’s common for markets to swing back and forth based on the latest economic data or market headline. This is completely normal and happens repeatedly in market cycles.
Why does the market pullback feel different this time around? Well, 2017 was an unusual year for the equity markets. A total return of 21% with 12 consecutive months of stock market gains was an aberration of normal market activity. That type of consistency over a calendar year had never happened before in stock market history and the largest correction seen last year was a mild 3%. The average intra-year decline in the S&P has averaged 13.8%, a correction we haven’t experienced since 2011. To even the most skittish investors, it’s been smooth sailing.
The reality is your portfolio looks nothing like the Dow Jones Industrial Average, nor should it. If the Dow dropping 1378 points in two days affects your overall financial plan, then you probably don’t have the right financial plan.
It’s times like this where we need to step back and realize that this is nothing new. Fortunately, our financial planning incorporates scenarios just like this, and many that are much more severe. No one can predict with confidence what the market will do over the short-term, but we can control our emotions, think rationally and maintain a well-diversified portfolio commensurate with our financial goals.