From Robust to Fragile, and a Comment on Something That Wasn’t Supposed to Happen

Last year’s US stock market was the definition of robust. Volatility was on the low side, and returns were high. Daily price movements were minor when the market sank, but high when the market rose. The S&P 500 corrected about 5.7% from mid May to late June – a decline that was markedly milder than the usual annual correction – only to surge to a new all time high less than two weeks later. Rarely is the stock market so satisfying.

This year, we are reminded just how rare last year was. In short order stocks are down 5%-7% depending on which index you prefer. Foreign stocks are off more. Volatility is rising: triple digit losses are back in the news and volume is surging.

The underpinning of this decline is uncertainty around the Fed’s gradual withdrawal from the bond market. Coincident with the Fed’s taper, China is showing signs of weakness (see our blog of January 4), emerging markets are having a rough go thanks to currency runs, and even some US data points are looking suspect. The confluence of these events is reminding investors that risk is increasing with the change in monetary policy. When risk increases, prices need to decline. The market is behaving as it should. At some point, prices will reach a level that accounts for the riskiness of the transition from lots of Fed support to less Fed support. That will be a buying opportunity.

On the other hand, interest rates were supposed to rise when the Fed tapered. “Everyone” says so. At least for now, this appears to be wrong. Interest rates are not up, they are down, and substantially, from the beginning of the year. In fact, the 30 year mortgage rate has ticked down, for the first time in months. Could it be that a Fed taper will not cause rates to rise?