Short and Sharp: Five lessons from the market sell-off

Recent market moves have undoubtedly shaken investors. Equally, however, they have reinvigorated bystanders – the investors standing on the sidelines waiting for buying opportunities. If I had to pick a side, I’d go with the latter. After all, the sell-off has not changed my views on positive fundamentals, but it has made risk asset valuations more attractive. Nonetheless, bouts of volatility like the one we have just seen will severely test investors’ resolve. Here are five lessons to keep in mind:

  1. Corrections are inevitable, and this one was long overdue: Market calm had been unprecedented. On average, the S&P Index has experienced a 5% drop every 90 or so days. Until last week, more than 400 days had passed since the S&P’s last 5% slump – the longest period since 1929. Borrowing the phrase usually reserved for internet-based travel deals, “If it feels too good to be true, it probably is.” It is worth noting that typically a correction that takes place against a backdrop of strong macro fundamentals tends to be short-lived.
  2. Changes in monetary regimes are unsettling: Markets have become accustomed to ultra-accommodative central banks. But this is changing. As global growths steams ahead, central banks are becoming more concerned about inflation. Shrinking balance sheets and rising interest rates will inevitably weigh on investor sentiment. Furthermore, with monetary policy being normalized, market dynamics – including volatility and duration of market cycles – are likely to normalize too.
  3. Periodic set-backs during late-cycle stages are likely: As is the way of late-cycle stages, valuations across risk assets have become very stretched and are vulnerable to a worsening growth/inflation mix. Tentative signs of inflation are now emerging – not least, last week’s fateful U.S. labor market data, which showed average hourly earnings rising at their fastest annual pace since 2009. Markets responded by re-pricing their Federal Reserve rate expectations, triggering a sharp rise in bond yields and derailing equity markets. Yet, as long as recession risk is low, a setback should be all it is.
  4. Technical market moves can hurt: Although the origins of the sell-off were rooted in concerns about rising inflation and the re-pricing of central bank expectations, the magnitude of Monday’s sell-off was almost entirely fueled by the unwinding of a crowded volatility-related trade. The repercussions of that unwinding include a several billion-dollar loss for investors, many of whom likely had not fully understood the complexities of the product.
  5. Don’t forget the fundamentals: Equity markets may have tumbled, but that has not affected the underlying strength of the economy. The United States is still in the midst of a very strong earnings seasons, corporate tax reform will provide a further positive catalyst, and global growth is strong. In addition, given the deflationary fears of yesteryear, central banks will remain behind the curve, not ahead of it. Further gains in risk assets are likely, so treat this market episode as a buying opportunity.

 

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