S&P 500 plunges nearly 4% on rising interest rate fears

Your success in investing will depend, in part, on your character and guts and, in part, on your ability to realize at the height of ebullience and the depth of despair alike, that this too shall pass. – John Bogle

Investors were given a harsh reminder last week that stocks can go down as well as up as the Dow Jones Industrial Average suffered its largest percentage decline in more than two years, a loss of 4.1%. The S&P 500 Index and the Nasdaq Composite Index also plunged, marking the first week this year that all three averages closed lower. The stock market had gone the longest period since 1929 without a correction of more than 5% so stocks were long overdue for a pullback. The first sign of trouble last week occurred on Wednesday when Amazon, JP Morgan Chase and Berkshire Hathaway announced plans to partner in order to find ways to reduce health care costs. This announcement sent stocks in the health care sector tumbling. Other ominous signs last week pointed to stronger than expected economic data, especially in the labor market, that raised inflation expectations and caused interest rates to creep up. ADP reported that private payrolls grew by 234,000 in January, easily topping estimates. The January employment report issued by the government on Friday showed that a better-than-expected 200,000 new jobs were created and that the unemployment rate remained at 4.1%. What was more surprising was that average hourly earnings increased 2.9% on an annualized basis, the biggest increase since the end of the Great Recession. This jump in wage growth sent bond yields higher and the 10-year Treasury ended the week with a yield of 2.85%, an increase of 44 basis points since the start of the year. The Atlanta Federal Reserve also issued a rosy economic growth forecast for the first quarter, predicting that GDP would increase by 5.4%. Faster economic growth coupled with rising wage growth raises inflation expectations and prompts fears that the Federal Reserve could become more aggressive in raising interest rates. Even though quarterly earnings reports were strong again last week, stock prices had gone up too far, too fast and were due for a pullback. Over 75% of S&P 500 companies have beaten fourth quarter earnings estimates and nearly 80% have also beaten revenue estimates, but much of this good news had already been reflected in stock prices. If interest rates can stabilize at these levels, the stock market should be able to regain its footing.

Last Week

Other economic data released last week was also positive. The Chicago Purchasing Manager’s Index (PMI) in January fell slightly but was still comfortably in expansion territory, suggesting that manufacturing remains strong. U.S. factory orders and construction spending in January were both better than expected. The University of Michigan consumer sentiment index and the consumer confidence index were also higher than anticipated as consumers remain optimistic about the economy and its prospects. The S&P Core Logic Case-Shiller survey showed healthy home price increases in November as a lack of supply fueled the price gains.

The Federal Open Market Committee (FOMC) met and decided to leave interest rates unchanged, although it does expect inflation to rise to its 2% target this year and will likely raise rates again in March.

For the week, the Dow Jones Industrial Average plunged 4.1% to close at 25,520 while the S&P 500 Index slid 3.9% to close at 2,762. The Nasdaq Composite Index dropped 3.5% to close at 7,240.

This Week

There are no significant economic reports scheduled for release this week but plenty of quarterly corporate earnings reports. Among the most prominent are Bristol Myers Squibb, GlaxoSmithKline, CVS Health, Sysco, Yum Brands, Archer Daniels Midland, Philip Morris International, Walt Disney, Viacom, Allstate, American International Group, Emerson Electric, General Motors and Anadarko Petroleum.

Portfolio Strategy

Investors may have become too complacent lately, but the Dow’s plunge of 666 points on Friday was certainly a wake-up call. While the drop was huge in absolute terms, it represented only a 2.5% decline for the day. By comparison, when the Dow fell 508 points on October 19^th, 1987, the one-day loss was 22%. The market has been so quiet that the last time the S&P 500 Index fell more than 2% was way back in September 2016. During the past year, there have only been eight days when the stock market moved up or down by 1% or more. Usually periods of above-average returns and low volatility are followed by periods of high volatility and below-average returns. The last few years have been characterized by steady economic growth, low inflation, low interest rates, strong earnings and optimism about global growth. It has been a near-perfect environment for stocks to perform well and for volatility to remain low. A slowdown in earnings growth or a realization that earnings may be peaking could increase volatility in stocks, especially with equity valuations that are stretched. Slowing economic growth or the possibility of a recession could also be problematic for stocks. The single biggest risk to the stock market may be an increase in inflation, which would lead to higher short-term interest rates as the Federal Reserve tightens monetary policy. If the 10-year Treasury yield reaches 3%, that would also be a headwind for stocks. The best way to ride out any volatility is to have a portfolio that is well-diversified and an asset allocation that contains a mix of stocks, bonds, alternative investments and cash that is appropriate for your investment objective, time horizon and risk tolerance.