The Anatomy of an 831-Point Decline - October 15, 2018

The Dow Jones Industrials fell 831 points, or 3.3%, on Wednesday (WSJ). Thursday saw a 546-point drop. A 1,175-point decline (4.6%) on February 5, followed by a 1,032-point drop (4.2%) on February 8, are the largest (St Louis Federal Reserve).

10 15 18 index

What happened? There’s no specific catalyst, but Treasury yields are a good starting point. Computer-generated trading added to the selling.

In a PBS interview on October 3, Fed Chief Jerome Powell said, “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don't need those anymore. They're not appropriate anymore.

“Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral,” he added. “We may go past neutral, but we're a long way from neutral at this point (my emphasis), probably.”

Higher rates hurt housing, may slow the economy, and can compete with stocks, But Powell’s right. The economy doesn’t need a fed funds rate at or near zero. Money that’s too cheap encourages bad decisions. Companies throw cash into projects that may not be worthy, economic distortions build, and major speculative excesses can develop. It’s something that usually ends badly.

But, are we a long way from neutral? It’s a curious remark, and one that forced the 10-year Treasury yield to its highest level since 2011 (Federal Reserve). A neutral rate means rates are neither too low—encouraging economic growth—nor too high—restricting economic growth.

What is the neutral fed funds rate? The Fed suggests it is 3% per its September projections. At today’s range of 2.00-2.25%, we aren’t far from neutral (3 more 0.25 percentage-point increases); so, Powell’s remarks appear to lean hawkish. Could we go well beyond 3% or increase the pace of rate hikes? He didn’t clarify.

Throw in international jitters and a slowing global economy, and short-term traders headed to the exits.

Conventional wisdom – rates and stocks

A couple of weeks ago, I shared a graphic that illustrated strong S&P 500 performance in the face of eight Federal Reserve rate hikes. It goes against conventional wisdom that rising rates hurt stocks.

But, how do stocks react to rising Treasury yields? The data aren’t decisively conclusive.

Table 1, which compiles data going back 60 years, suggests the biggest spike in yields works against stocks. During the period when yields rose the most, the average monthly decline in the S&P 500 Index was 0.12%. Other than that, falling yields or a modest increase didn’t slow shares.

10 15 18 table1

Table 2 reviews data over the past ten years. We see almost the mirror image of the 60-year period. More recently, the biggest decline in yields hampered stocks.

10 15 18 table2

Why the dichotomy? When rates are already low, a big drop in yields is usually viewed as the byproduct of economic uncertainty, and economic uncertainty hurts stocks. One conclusion we can draw – stocks have a long-term upward bias. We can also say that rising rates do not necessarily send stocks lower.

An inflection point?

Are we shifting back to a period when a spike in yields creates a stronger headwind for stocks? That’s difficult to conclusively answer.

Rates remain low, historically speaking. Excluding recent years, a 10-year yield hovering near 3% is a rate we have not seen since the late 1950s (St. Louis Federal Reserve).


Through October 11 and excluding Friday’s rally, the S&P 500 Index had fallen 6.9% from its September 20th peak (St. Louis Fed). This is the 23rd time since the market bottomed in March 2009 that the S&P 500 has declined more than 5%, Charlie Bilello, Director of Research at Pension Partners tweeted on Wednesday.

Some folks take these selloffs in stride. Others are unsettled by them. Markets take the stairs up and seem to take the elevator down. It is a normal part of investing. Longer term, the historical bias has been to the upside, as demonstrated by the illustrations above.

We won’t try to guess where stocks might trade this week. But it would be more concerning if stocks were falling in the face of weak economic data and falling corporate earnings. That’s not the case right now. If rates are going to normalize, stronger economic growth is the right reason.

Oh, one more thing

On Thursday evening CNBC ran a special, “Markets in Turmoil.”

While I must offer the disclaimer that past performance is no guarantee of future results, Charlie Bilello tweeted Friday that every time CNBC has run “Markets in Turmoil,” the forward total return on the S&P 500 has been up three, six, nine, and 12 months later.

Since 2010, they’ve run 24 specials, including Thursday’s edition and two last February.

One week and one month following Markets in Turmoil, the S&P 500 has been down six times and eight times, respectively.