Younger market participants might be flummoxed by what is happening in stocks in 2018; since 2012, really, the stock market has been on a constant upward trend with few moments of weakness that relatively quickly reversed themselves. This year, however, feels different; since the spike in volatility at the start of the year, stocks have remained weak, remaining flat to down slightly for the year even after strong earnings growth and various positive macroeconomic data such as unemployment, wage growth, and GDP gains. So what exactly is happening?
We can point to two distinct causes of a decline in stocks, and each is both different from each other and important to consider on their own merits.
Cause 1: Profit Taking
Stocks went up over 20% in 2017 after having a strong showing every year since 2011. That is one of the longest, and strongest, bull runs in the history of the stock market. So now that a lot of macroeconomic data is looking positive, some investors are worried that all the good news is priced in—so it’s time to finally take some of the massive profits that have accrued over the last decade.
This is the most benign and healthy driver of stock weakness. It doesn’t mean a loss of confidence, but a market perception that moderation is necessary. That would imply that smaller, slower gains are likely to come in the near term, assuming all else remains the same.
Cause 2: The Yield Curve
Every modern recession was precipitated by an inverted yield curve, where interest rates for short-term Treasuries were higher than yields for long-term Treasuries.
The inversion doesn’t have to happen for very long—in 2007, the negative inverted yield curve lasted just a few days—but it demonstrates that interest costs for debt have gotten far too expensive for the market to bear. When this happens, people stop paying their debts and a sudden lack of confidence is inevitable. Collective belt-tightening means a fall in income, thus a fall in earnings for corporations, which makes the debt load even harder to manage. The vicious cycle is complete.
The yield curve has been falling since the start of 2014 and has gone from 2.4% to 0.45% in a little over 4 years. It hasn’t been this low since 2007—so concerns that a recession is around the corner is keeping stocks weak.
These are two very different, even contradictory, rationales to explain stocks’ recent weakness. They also lead investors to consider two metrics going forward: the yield curve (inevitably meaning a focus on the Fed’s plans for interest rates) and fund flows through different asset classes—which should tell us how rational this sell off is.
Understanding any moment of weakness for stocks is crucial, because it helps investors understand whether there is a significant storm coming—or if the market is just having a short-term temper tantrum. Mistaking the former for the latter can cause a premature withdrawal of funds from the market, resulting in months or years of missing out on significant profits.