Roller Coasters Used to be for Amusement Parks

Feb 9, 2018   //   by Bruce Mason   //   Weekly Market Update  //  No Comments

Let’s talk about the elephant in the room.  The markets have, at least temporarily, entered a more volatile period.  After breaking the record for the longest streak without a five percent pullback, we returned to normal.  However, the truth is we have a long way to go before we return to “normal.”  Late last year, the markets went into overdrive, with the Dow hitting new 1,000 point milestones on what seemed a weekly basis.  It felt good on the way up but created a short-term dislocation running far ahead of itself.  The pullback we’ve experienced brings us back in line with the long-term trend which, for now, remains intact.  I can’t say we won’t see more days of unusual volatility, but I can tell you the underlying fundamentals haven’t changed.  The economy remains on solid footing with no signs of slowing down.

In fact, the issue isn’t that market participants worry about the economy slowing down, they worry it may speed up.  The problem is inflation and its something we haven’t had to talk about for many years.  The Federal Reserve (Fed) has two mandates: keeping inflation at 2% and achieving “full employment.”  Most economists believe we’re at full employment with the unemployment rate around 4%.  The second mandate is more tricky and will be the focus of Fed policy for the foreseeable future.  With unemployment possibly breaking below 4% this year, we’re beginning to see wage pressure.  As wages rise, so too will the price of the goods and services companies charge.  The way the Fed combats this is by raising interest rates, which they started last year and are expected to raise three times this year.  What the market collectively said this week is, “we think rates will have to rise faster than had been expected.”

But let’s talk about another factor that drives volatility.  For decades the stock market was the hallmark of people, namely market makers, who provided liquidity that allowed the markets to function properly.  Over the last fifteen years, market makers have slowly been replaced by computers.  It started with algorithmic trading but has evolved into high-frequency trading (HFT).  HFT strategies utilize computers that make elaborate decisions to initiate orders based on information that is received electronically before human traders are capable of processing the information they observe. Algorithmic trading and HFT have resulted in a dramatic change of the market microstructure, and to a large degree account for the volatility we’re experiencing.  Intra-day thousand-point swings aren’t caused by retail or institutional investors.  This is the realm of autonomous computers.  It’s a future that can’t be stopped but will hopefully be more aggressively regulated in time with limits on how far the market can be distorted before breakers are triggered.

We remain optimistic about the economy and view current market swings as part of the usual cycle, albeit faster and more exaggerated than is typical.  We cannot know what Monday holds, but we are confident that by focusing on long-term strategies and goals we won’t be victim to these short-term swings.  Warren Buffet put it best when he said, “I will tell you how to become rich.  Close the doors.  Be fearful when others are greedy.  Be greedy when others are fearful.”  We have entered a period where people are now fearful.  In time this will fade, but for now at least, the ride is going to be bumpier than it has been.

February 9, 2018

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