For anyone who missed the action, the stock market as measured by the S&P 500 Index (SPX) dropped into a classic correction at the close on Thursday, February 8, as it ended the day down 10.16 percent from its record high reached at the end of January. So far, it appears to be one of the shorter corrections in recent history as it closed on Friday at 2619.55, up 1.5 percent for the day, still down 8.8 percent from the high but out of the -10 percent range that is informally considered a “correction.” That put the index down just over 2 percent year-to-date but still up over 13 percent from a year ago.
The benchmark 10-year US Treasury Note bobbed up and down but ended the week at 2.857 percent with 2/10 of a percent higher yield than last week. That Note has now seen a rise in yield of about half a percent in three months. At the low rates of three months ago, that rise in yield amounts to a 22.4 percent increase in rates in a quarter of a year. That rise in rates translates to a loss in market value for investors holding the notes.
In what to many will be an unexpected move, gold prices declined 2.2 percent as the stock market sank, although it remains up 5.5 percent for one year.
There have been no small number of ideas floated as to why this correction took, or is taking, place. Every index of leading economic indicators continues to forecast smooth sailing and an improving economy for the next six months to a year. Earnings being reported by publicly traded companies continue to be above estimates for about 80 percent of reporting companies, a record. Factory orders and purchasing managers indexes too continue to suggest better times ahead. With all that good news, why would the stock market suddenly take a 10 percent plunge? It appears to us that there were two elements in this short-lived correction that are warning flags. The first is that the combination of tax cuts and dramatic spending increases has the potential to create some serious problems down the road.
The U.S. federal government is going to need to borrow over $1 trillion just in 2018 and that is just the down payment. The spending bill passed by Congress on Friday morning should add another $200 to $300 billion to that this year. More, the hit will be bigger next year. Over the next seven years the addition to the national debt, earlier advertised as about $1.4 trillion from the tax bill, has effectively been increased around $3 trillion
The conclusion reached by investors that appears to have set off the run for the door is that the combination of the need for the federal government to borrow $3 trillion and the infusion of that much money into the economy but increased government spending will likely trigger some serious inflation. The combination of inflation and rising Fed rates will make corporate borrowing much more expensive and cut into future corporate earnings. It just makes sense that if higher borrowing costs are likely to reduce corporate earnings by about 10 percent, a 10 percent decline in stock prices is in order. The reaction appears to have been magnified by large scale selling of index funds to cover options losses for investors who have bet against high volatility.
The other red flag issue was that several of the major do-it-yourself advisory services such as the ones at Fidelity, Schwab, Betterment and others crashed as the market plunged. The concept of robo-advisors maintaining portfolios of exchange-traded index funds was seen by many as a “sure thing” that would limit losses and give higher returns. As with other historical “wealth without risk” schemes, this one failed when it was supposed to provide greater safety. The companies responsible were able to get things up and running again fairly quickly but this was only a minor stumble, not a panic. The lesson is that there are many investors who are depending on untested technologies to limit risk. If those technologies failed in a minor correction, they could be a time bomb for a bigger fall later in the year.