How a Strong Economy Can Make the Stock Market Indices Go Down

5a612880a00d8.imageIn the last three trading days the S&P 500 Index has dropped 7.8% in value, virtually wiping out all of the impressive gains it made in the month of January. Markets go both up and down, but for the last 13 months the stock markets have been going only up; in fact, the Dow Jones Industrial Average was up over 26% from January 2017 to January 2018.  This has caused many investors to forget that trees don’t grow to the sky, and with the Dow shedding 1800 points in three trading days, many investors are concerned about what lies ahead.

Let me be clear: as of this writing, the stock market is not in a correction. A correction is defined as a 10% drop in a stock index from a previous market peak. Since March of 2009, we have only experienced four official corrections, and this is uncommon. Historically, markets can experience one or two corrections a year. Occasional price declines are a natural part of the investment process, and they must be expected and accepted for investors to experience the wealth creation opportunities that come from stock ownership.

This may sound counter-intuitive, but the primary reason for the recent decline in stock prices is economic success. “The Fed” (the Federal Reserve), has been tasked since 1977 to accomplish two diametrically opposed missions: 1) maximize sustainable employment; and 2) maintain stable prices. For nearly a decade, the Fed has been keeping interest rates at historical lows trying to encourage people to stimulate the economy by spending the money they borrow. As people spend money, they increase demand for goods and services, and this in turn creates jobs, which leads to an increase in the number of people who are employed. However, low interest rates and the recent tax reform bill have created a situation where demand for workers is high, and employers are raising the wages they pay, causing even higher demand for goods and services. As a result, low interest rates no longer appear to be necessary to increase employment. Now that the Fed is no longer concerned about unemployment, investors are now worried the Fed will begin raising interest rates to accomplish its second mission: preventing price inflation.

On Friday, February 2nd, the Labor Department released its monthly jobs report, and the news was good. The economy added 200,000 new jobs, and wages grew at an impressive 2.9%, the highest growth rate since 2009. Normally, good economic news would be worth celebrating; however, on Wall Street, good economic news can often lead to predictions that the Fed will act to control future price inflation. A good way to think of low interest rates is they are like caffeinated coffee which stimulates the economy, and thus increase employment, and high interest rates are like sleeping pills designed to slow down a growing economy to prevent price inflation. In essence, the Fed attempts to pump up the economy with low interest rate caffeine, and when it gets too stimulated, the Fed attempts to subdue the economy with high interest rate sleeping pills.

Stock prices are primarily dependent on what investors think about the future profitability of stocks.  For example, if Company XYZ has a share price of $20 and is expected to increase its earnings from $1.00 per share to $1.30 per share, in theory, the price of the stock should increase to a price around $26. This is because a $20 stock producing $1.00 of earnings is similar in value to a $26 stock that produces 30% more earnings. While the science is not that exact, the fact remains that investors tend to pay prices for stocks based on what they think the company’s earnings will look like in the future.

Bottom line: investors think the Fed will raise interest rates to prevent runaway price inflation, and raising interest rates will also reduce the potential future earnings of companies.  In the above scenario, investors who believe a $20 company is expected to grow its earnings over the next year from $1.00 to $1.30 in a low interest rate environment, may now believe with rising interest rates the company will only be able to grow its earnings to $1.20, causing the stock to fall to $24 from $26.

Finally, Wall Street can handle good news and bad news, but it loathes uncertainty. Fed Chairman Janet Yellen’s last day on the job was Friday, February 2nd. The markets loved Yellen because she kept interest rates low. The new chairman, Jerome Powell, is an unknown who has no real history to reveal how he will lead the Fed. Wall Street doesn’t know if Powell will aggressively raise rates; or, like Yellen, choose to keep interest rates low. In the absences of certainty, Wall Street tends to pessimistically assume the worst.

The economy is doing well, but it is possible stock prices may not grow as rapidly in the near future if the Fed aggressively starts raising interest rates in a battle to keep prices stable. While the stock market on Monday, February 5th dropped 1,175 points – the biggest single day drop in history –  on a percentage basis, this drop didn’t even make the top 50.  Investors should consider this recent drop as a normal part of the business of investing, and not necessarily a harbinger of a bear market.