Why Has the Stock Market Declined? (In Simple Terms)

The modern stock market has been around since the 17th century when the first exchange was organized in Amsterdam. It is safe to say that at no point in history have so many individuals and families had so much of their savings invested in the stock market – generally through mutual funds or other retirement vehicles.

Close to 60% of Americans now have some direct stake in the stock market according to Gallup, through direct investments, pensions, 401ks, or IRAs. Yet, the stock market remains a black box to most of those investors. Case in point: why, all of a sudden, has the market been tanking? Seemingly out of nowhere, the broad U.S. market has lost 10% of its value after performing solidly for quite a while.

Nobody can predict the short-term movements of the market. On any given day, the market has about a 50% chance of rising and 50% chance of falling. Should someone develop an algorithm that correctly predicted what the markets would do the following day, traders would buy and sell stocks in advance of the prediction and destroy the pattern. Investors can make intelligent decisions about longer time horizons, however, which feeds into the original question of why the market has been falling.

The stock market is valued using three primary factors: corporate earnings, long interest rates on government bonds – or rates that could be nearly guaranteed and free from default risk, and a so-called “risk premium,” or the return that an investor would need to entice him or her to invest in the stock market as compared to less risky government debt.

The picture for corporate earnings looks pretty good. During 2017, one share of an S&P 500 index represented about $130 of earnings, and analysts are estimating that that number will swell to around $150 in 2018, thanks to accelerating economic growth and lower corporate taxes. But, how much those earnings are worth depends on the rate of return an investor requires in the stock market – that’s determined by long-term government interest rates and an appropriate risk premium.

Long-term interest rates have been very low for some time now. For an extended period of time, the 10-year treasury provided investors with a nominal return of close to 2%, despite the fact that over the very long-term returns have been about 4.5%. Nominal returns in the stock market have been about 10%, so traditionally investors have required a 5.5% “risk premium” to entice them into the stock market when the 10-year treasury rate is used as a comparison.

With interest rates as low as they have been, most investors have been willing to also settle for less of a return in the stock market, pricing it to return perhaps 6%-7% in the long-run rather than the historical 10%. But, if interest rates were to rise, the price of the stock market must fall to provide a correspondingly higher return. That’s exactly what has happened.

The 10-year treasury has gone from a yield of 2.05% on September 5th to 2.86% today and many are concerned that the steep rise in rates will continue. Last month’s jobs report showed much higher wage growth than prior reports – stoking inflation fears that could cause the Federal Reserve to raise interest rates at a faster pace.

Higher interest rates are not bad news for everyone. Younger investors, who will be net buyers of financial assets for decades to come, should welcome higher interest rates and lower stock prices. And while investors’ fears are rational, so far inflation has not yet shown a definitive uptrend.

The long-term average multiple on expected earnings in the coming year for the S&P 500 is about 16. With the current multiple at 17.7, the market could fall another 10% if investors priced it for a more normal interest rate environment. But, interest rates are still a long way from their historical average.

For most savers, placing a small amount of money regularly into a retirement plan, they should be unconcerned with market movements such as we have recently experienced. As those savings are dollar-cost-averaged into the market they are extremely likely to outperform bondholders over time and should attempt to time the market by moving heavily out of stocks only at times when the market is selling for irrational valuations. We’re not there…yet.

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