We have spent the past couple of days worrying about the market dropping. Indeed, today we have a further decline. This volatility isn’t unexpected, certainly. But the further down we go, the more worried we should be—and the more inevitable further declines look.
Given all the bad news out there, further drops do seem reasonable. We have the U.S. midterms, Chinese slowdown, Saudi Arabia, Italy and Brexit, the Fed raising rates, and on and on. It seems, all of a sudden, the bad news has become overwhelming. In the face of such turmoil, what could take the market back up?
Reasons unknown
If you think about it, the question answers itself. All these events, with the exception of Saudi Arabia, have been in the public eye for months, if not years. The Saudi situation, although a tragedy, is neither unprecedented nor likely to have much of an economic effect. So, why the reaction now, when we didn’t see it earlier?
The answer (as I see it) is that sometimes, for some unknown reason, markets just lose confidence. Whatever bad news is out there is often held up as the reason. We saw this in early 2018, 2016 and 2015, 2011, and so on. Sometimes, there is no apparent reason for turmoil at all, as in the flash crash of 2015. Sometimes, markets just throw a fit.
It certainly doesn’t make it any easier to ride out, of course. But that is what seems to be happening. Despite the reasons enumerated above, none of them should have a meaningful impact on the economy or the market, at least in the short term. There was no reason for the markets, all of a sudden, to react like they have. What we have above are excuses for the pullback, not fundamental reasons.
Looking closer at the pullback so far—which, as I have noted before, hardly deserves the term by historical standards—we see that to be the case. Earnings estimates have not moved significantly. Economic growth continues to be healthy. It is a matter of confidence, of belief about the future, that has changed and not the fundamentals.
What if . . .?
If you accept that reasoning, it also points to how the market can recover and even move higher. If confidence is the problem, what would restore confidence? What if, for example, the Saudi Arabia situation were resolved? What if a Brexit deal and an Italy deal were cut? What if Chinese growth recovered? If we took all, or some, of those worries away, wouldn’t confidence improve? What is more likely: that all of these bombs will go off or that they will be resolved? Lots of things can happen, but relatively few actually do.
Here in the U.S., one worry I can guarantee will pass in the reasonably near future is the U.S. midterms. For all the angst and worry, they will be over in a couple of weeks. Even more, once they are over, there are only two possible outcomes. First, the Republicans retain control, which will likely be positive for markets. Second, we have mixed government and gridlock, which has also historically been positive for markets, or at least not bad. In a couple of weeks, a major worry will resolve itself and will likely do so in a way that reduces market worries.
So, what do we need?
With fundamentals healthy—and they are—pullbacks tend to be short, even if they are sharp. We don’t need great news to pull us out of this one. We just need the level of worry to subside. The more worries there are, the more likely it is that many won’t come to pass. We don’t need the market to feel good to rise, just less bad. And that looks like a very possible outcome.
By Brad McMillan, CFA, CAIA,
All the best,
Wesley R. Nicholson, Mike Allen and Aaron Everdyke