The Economy, and Lessons Learned from Last Week

After a series of four consecutive 4% daily swings up and down, the stock market has enjoyed reduced volatility over the past three days. So it is a good time to look towards the future and reflect on the recent past. The main driver of the stock market over the next few weeks is likely to be the economic outlook for the U.S. and Europe. In the U.S., many economists are lowering their forecasts for economic growth, which is adding to concerns about a possible recession. However, none of the broad economic surveys I have seen are predicting a recession, and recent aggregate corporate profits have exceeded expectations. With respect to Europe, in the past week key economies such as France and Germany have reported lower growth than previously expected, which is triggering concerns about a recession there as well.

The volatility we saw last week is evidence that there is no consensus how the U.S. and European economies will be performing over the next few months. And, unfortunately, the lack of consensus probably means that despite the relative calm of the past couple of days, we will continue to see spikes of market volatility in the near future. And we know any sign of volatility will be highlighted by the media.

Last week’s volatility was described by many in the press (and even some financial advisors) as “unprecedented in the history of the market,” specifically alluding to the five wild days of price swings. What is truly unprecedented is the memory loss of those commentators. Below are two graphs comparing the returns of the S&P 500 of last week with weeks during 2008 (only three years ago) and 1987.

Daily returns of the S&P 500 in 2011 and 2008

Daily returns of the S&P 500 in 2011 and 1987

As you can see, we have had much more volatile weeks, even in our very recent past. The specific pattern might be unusual, but if one defines any pattern specifically enough, every event that occurs in life is unprecedented (these commentators should not go for a hike in the woods, because every tree will amaze them so much that they certainly will get lost).

Unfortunately, hyperbole in the press and advisors is not a harmless act. I know two living, breathing investors who last Monday, after being barraged with press reports and emails about the market, sold every one of their stocks and equity mutual funds, leaving them with 100% cash and bonds. Of course, those investors can buy back into the stock market, but one week later, those same stocks will cost 8% more than the price for which they were sold (based on the returns of the S&P 500). The “sell low, buy high” behavior in response to market volatility can, in one day, destroy more value to a portfolio than an average year of equity returns can add.

Is there any action you should consider in response to last week’s movements? If you were able to look at the fluctuations relatively dispassionately, then the answer is no. However, if you were seriously tempted to call your advisor and exit the market, it might be a sign that your long-term allocation to equities is too high for your level of risk tolerance. There probably will be similar (or even greater) spikes in volatility in the future – maybe not in the next month, or even the next year, but eventually. If a long-term reduction to equities of 5% or 10% might provide you with more security, it would be better to take that action now instead of panicking at the bottom of a market.

With respect to the stock market, reaction is typically not right action.

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