Investors rushed toward the exits yesterday, as the Dow Jones Industrial Average fell by a whopping 665 points. This was the sixth largest point loss in Dow history and a bigger drop than on Black Monday in 1987. As troubling as this may sound, the loss in value was only 2.54 percent. The first lesson is that investors should divorce themselves from focusing on point changes and simply monitor percentage changes.
Some market watchers are suggesting that this is signaling the end of the so-called “Trump bump.” Suffice it to say that forecasting near-term movements in financial markets is a futile endeavor. Vanguard founder Jack Bogle said, “I have never met anyone who can consistently time the market. In fact, I have never met anyone who has met anyone who could do so.”
The answer is really pretty simple and has to do with the expected path of future interest rates. The economic data released yesterday also showed that average hourly wages rose, pushing the yearly wage increase to 2.9 percent. This was the strongest wage gain in more than eight years and raises the specter of increased inflation. This, in turn, may lead the Federal Reserve to move more aggressively in the near term to raise interest rates. You see, rapidly rising rates are anathema to stock investors.
Stocks and bonds compete for investor dollars. As interest rates rise, the attractiveness of bonds rises and the attractiveness of stocks declines. Five months ago, the 10-year Treasury bond was yielding a scant 2.2 percent. That corresponds to an bond price-earnings ratio of 45.5. With increased inflation worries, that same 10-year Treasury bond now yields 2.83 percent.
The bond price-earnings ratio has fallen to 35. Buying bond income has become much less expensive in a short period of time. Now, I would argue that bonds are still relatively expensive compared to stocks, as the current price-earnings ratio on the S&P 500 index is near 26. But, the gap is certainly closing.
The market weakness we witnessed this past week is simply a natural correction and a reminder that markets don’t go straight up. In addition, history shows that stock market returns are much lower in rising interest rate environments than in falling rate environments. In other words, the direction of interest rates matter.
In “Invest with the Fed,” Gerald Jensen of Creighton University, Luis Garcia Feijoo of Florida Atlantic University and I found that from 1966 through 2016 the S&P 500 returned 15.2 percent when interest rates were falling and only 5.9 percent when rates were rising.
My advice to long-term stock investors is to relax and stay invested. This too shall pass. On the other hand, you speculators and short-term investors are on your own. The good news is that those Dow 26,000 baseball caps can be reused.
Robert R. Johnson, PhD, CFA, is president and chief executive officer of the American College of Financial Services. He is co-author of “Strategic Value Investing,” “Invest with the Fed” and “Investment Banking for Dummies.”