Over the past several days, we have experienced a sudden rise of financial market volatility in response to incoming economic data and related events. On Wednesday, July 31st, the Federal Reserve left interest rates unchanged, as expected, but was somewhat disappointing to the growing chorus of pundits who believe that the Fed should already be lowering rates to counteract a slowing economy. On Thursday, August 1st, we received two economic reports, the ISM Manufacturing PMI and the U.S. weekly jobless claims that were both weaker than expected. Then on Friday, August 2nd, the Non-Farm Payrolls report fell well below expectations, with the unemployment rate rising to 4.3%, causing further concerns of an impending recession.
Concerns of a possible recession were intensified by two other unofficial indicators. One is called the “Sahm Rule”, which was triggered on Friday, that has successfully predicted each recession over the past half century. (The rule indicates a recession has begun when the three-month moving average of the US unemployment rate is 0.5 percentage points or more above its lowest point during the previous 12 months.1 ) Another indicator is the shape of the Treasury yield curve. The yield curve, when inverted, usually signals an impending recession. And when the curve starts steepening, that has historically been a sign that a recession has already begun.
On Monday, August 5th, global equities and commodities continued to sell off sharply, with broad based declines led by the technology and cyclical sectors. At the same time, U.S. Treasury yields continued to decline meaningfully. While it may be challenging to discern the implications of these recent market swings, there are a few key principles we continue to employ given our decades of experience managing portfolios through many different market cycles.
- Market Corrections Are Normal. Although perhaps uncomfortable, equity market selloffs are normal and to be expected. In February 2022, Schwab published an article titled “Market Corrections Are More Common Than You Think”. In their research, they studied market corrections between the years 2002-2021. They noted that “a decline of at least 10% occurred in 10 out of 20 years, or 50% of the time, with an average pullback of 15%” 2. So given the run up of equity markets in 2023 and 2024 (mainly driven by a handful of large companies), a correction was perhaps warranted.
- Proper Risk Management Techniques are Always Required. It has been perhaps beneficial to throw caution to the wind these past couple years. Risk management techniques – including diversification and valuation – have fallen out of favor in light of the outsized performance of the S&P 500 and Nasdaq 100 indices in recent years. But the lack of attention to risk analysis and disciplined investment process are beginning to reveal their flaws. One such peril was the exuberance surrounding Artificial Intelligence (AI) over the past 18 months, which was on an unsustainable path given the risk of inflated expectations. Rather, reasonable growth expectations and sound valuation methods are always necessary for protecting downside risk. Furthermore, those who gave up on fixed income securities following their poor 2022 returns are likely now facing regret.
One’s assessment of risk management should not depend on how the markets and economy are performing. Rather, it should depend on the overall objective of the client which should remain relatively consistent.
Final Thoughts
Recession or no recession, there is one key point to note: Do not overreact! Historically, trading impulsively during volatile markets can create unwarranted risk to one’s long-term financial plan.
At Caplan Capital, we are focused on designing portfolios to meet each client’s long-term objectives and risk tolerance. As we seek to successfully achieve these goals, our portfolios are built with a sharp focus on risk management to account for a wide range of outcomes given the perpetual uncertainty of markets and the economy. Amid recent market volatility, we will continue to closely monitor the markets and the economy to help ensure that our client portfolios remain in a strong position to navigate through challenging times.
Sources
[1] https://www.barrons.com/news/what-is-the-sahm-rule-behind-the-market-panic-78c20663
[2] https://www.schwab.com/learn/story/market-corrections-are-more-common-than-you-think
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