Is it time to panic?

After about 20 months of essentially unfettered gains, the S&P 500 has gone backwards pretty sharply in the past week. Since the close on Thursday, Feb. 1, the SPY ETF (which tracks the S&P 500) has declined 7.1%, seeing some of its largest single-day declines in over 5 years.

Occurrences like this can be unsettling for investors, but in this article, I wanted to share some thoughts on the declines, put them into perspective, and offer some opinions on where we go from here.

Putting It Into Perspective

Major financial publications have been touting recent declines in the Dow as "the largest one-day drop since the Great Recession", "the worst point decline in history", and "the largest one-week drop in 9 years".

All these may be true, but I prefer to look at the S&P 500, a better barometer for the overall stock market. The Dow tracks only 30 stocks - less than 10% of the S&P 500. Measured by market cap, the Dow tracks about $6.7 trillion, less than 1/3rd of the S&P 500's $24 trillion. Essentially all mutual funds, ETFs, hedge funds, and newsletters (including ours) benchmark against the S&P, not the Dow.

That said, the S&P 500 has declined over 7% since the start of February. Is this a sign of major declines to come?

First of all, let's take even a slightly larger perspective. Even after this decline, the S&P 500 is down about 2% in 2018 - hardly disastrous. After a nearly 20% gain in 2017 and a nearly 50% gain in the preceding two years, a flattening out or even a slight decline in the averages could be considered natural, even healthy.

The recent drop's magnitude isn't even particularly notable when put into recent history.

Consider the S&P 500's incredible performance since 2010. The index is up an impressive 135% since the beginning of 2010. But in those 7+ years, the index has seen no fewer than 7 declines larger than this one within periods less than a month. Many of them have been far bigger declines than this one. Consider:

In addition to these, there were two other 2-week periods in both 2010 and 2011 where the S&P declined over 6.5%

We've gotten too used to the steady upward march of the past few years, not realizing that markets are naturally choppy, with short-term ups and downs that have, historically, turned into upward cliffs when zooming out to longer periods of time.

A short-term drawback, even a sharp one like this, is not really that unusual, nor is it unexpected after a very long and (in 2017) unprecedented string of gains. We certainly don't feel there is any reason for panic. Panic is never a very good strategy in investing.

Leading Indicators Are (Mostly) Benign

The major risk of a longer term stock market decline is, of course, an economic recession. Are there any forward indicators that should lead us to this concern?

Perhaps the single most important economic indicator is Real GDP. In its most recent report, the Department of Commerce pegged real GDP at 2.6% for the 4th quarter of 2017, slightly lower than the 3% figures for Q2 and Q3, but well above Q1 (about 1.3%) and Q4 2016 (1.8%). Real GDP for the entire year 2017 should come in at around 2.5%, which would be the best year since 2014 and above the average growth figure for the past 12 years. So, overall, the general U.S. economy looks healthy.

Another key indicator is the National Unemployment Rate, a historical chart of which can be found here. We can see by looking at this chart that January 2018's rate of 4.1% is consistent with the preceding 3 months and which represents the lowest unemployment figure in the entire chart, dating back to 2008. In fact, current unemployment rates are some of the lowest since the late 1990's and - before that - the 1960's! Unemployment is low and steady.

Market valuation is another thing to watch closely. The current forward P/E of the S&P 500 is 16.5, now at its lowest level since mid-2013. Looking at a historical chart of valuation ranges for the S&P, we can see that this figure is actually a bit below the average forward valuation in the past 20 years. Certainly, we are not looking at a "bubble" valuation like we clearly had in the late '90's, and neither are we in the low 10's area like we were in 2008-2011. It's pretty benign.

Finally, let's talk about the data point that kicked a lot of this downturn off - the fed funds rate, which faces future hikes. A rise in the fed funds rate leads to interest rate rises across the board, making it more expensive for companies to borrow capital and for consumers to borrow to buy houses, cars, etc. Since mid-2009, the fed funds rate has been consistently held at the lowest levels in its history, less than 0.10% for many years and even now just 1.42%, still remarkably low historically (see this chart). A few increases from here is logical in order to keep inflation in check, and should still not make borrowing prohibitively expensive. It is something to watch, but at current levels, I don't feel it is a major economic risk.

So, as you can see, some of the most important economic/recession indicators are pretty benign and - at least at this point - don't seem to raise much cause for investor concern.

Staying the Course

Taking emotion out of the equation and looking at this recent drop from a measured perspective, it seems more like a natural pull-back from a roaring stock market than a harbinger of more bad things to come. The decline is not particularly unusual from even a recent historical perspective, and nearly all economic indicators remain positive.