So stocks declined almost 3% last Friday and were again slaughtered today, being down 4% and thus erasing all the gains made so far in 2018. Stocks in Europe and in Asia have also experienced sharp losses starting last week and even more so today.
A 4% decline by the way corresponds to a 4-sigma event, meaning 4 standard deviations above the mean. According to the normal distribution such an event should occur only every 100 years or so, but in reality does happen maybe twice within a decade. Stock market returns do not follow a normal distribution but have fat tails, meaning that outliers occur much more frequently.
So why shouldn't we be worried? Well, economic fundamentals have been very strong recently with quarterly GDP growth humming along at plus 3% over the last three quarters in 2017 and economic forecasts implying another good quarter for 2018. Moreover, global economic activity has recently picked up as well, this being true both for the Eurozone as well for emerging markets.
More recently, a few articles have argued that rising bond yields might ultimately choke off the stock market rally. This reasoning was somewhat flawed as you should never reason from a price change. Instead, you need to think about what has shifted, demand or supply.
Rising bond yields across the globe reflect to some extent better macroeconomic fundamentals and higher inflation expectations, which normally should rather be a positive for the stock market.
On the other hand, elevated price earnings ratios implied that the US stock market valuations started to be stretched, maybe not in bubble territory but relatively high from an historical point of view (of course, one should not forget that low real interest rates imply higher asset price fundamentals).
In 1987, the Dow Jones crashed by more than 20% within a single day, an event that by the way should not happen according to the normal distribution, and the economy did just fine. Of course, everything will depend on the reaction function of the Fed and interest rates are still relatively low, meaning that the Fed does not have unlimited firepower in the case an economic downturn will occur.
Ultimately, I think that this is just a temporary blip in the market, meaning that it will not really have a big impact on consumption and investment decisions. But only time will tell.
Don't panic !!!
Dow Jones: down by almost 9% from a week ago