Your October Monthly Market Recap

What Caused the October Stock Market Decline?

One thing that’s always kind of freaked me out is how quickly things can turn on a dime. I know, that’s the way life goes sometimes, but it still can feel a bit unnerving. And evidently, I’m not alone, at least if this past month is any indication.

Prior to this past October, the economic data hitting the news read like an investor’s dream. The US economy was booming, wage growth was picking up steam, inflation was contained, and American stocks were on track for another year of double-digit returns.

Most economies outside of the US were also doing very well—in fact, every single major economy was displaying expansionary tendencies. It’s not often that synchronous growth occurs around the globe, but everyone seemed to be playing their part and marching ahead. Life was good.

Then, October came through like a wrecking ball. Everyone got spooked—weeks before the actual ghouls and goblins came out to play, and in turn, stocks took a dive. Things were going so well prior to this, so what happened?

Factors of the October Stock Market Crash

As is often the case in financial markets, there are innumerable factors that are responsible for the recent downturn and no one can pinpoint the exact “why” of it all. But, pundits will nonetheless point their fingers and try to explain it. Simply put, these events can usually be attributed to one broad and unsatisfying explanation: changing expectations.

Investors consider three things when they buy anything: the history, current state, and expected future value. It could be a hot new tech company, a piece of real estate, even a car or collectible lunchbox. Where has it been, and what is its story? What does it currently look like, and is it in good shape? What are its projected future prospects and value?

The answers to all of those questions help determine the price at which the investor would purchase the item. Depending on the “thing,” the history and current state are relatively easy to determine since they’ve already happened; you just need comprehensive and accurate data. It’s the expected future value part that usually trips people up and is what most investors spend their time trying to suss out.

Shifting expectations about future value is usually what is behind most market movements. Generally speaking, if investors expect global growth to keep booming, they’ll have no qualms about buying stocks at lofty valuations because future growth will justify that high price. But if they start to believe that a recession is within sight, those prices will most definitely come down.

At the beginning of the year, the vast majority of economic data painted a pretty picture—falling unemployment figures, strong GDP growth, and consumer confidence levels nearing all-time highs.The problem with really good economic data when it comes to investing, however, is that it’s not a secret. It is the current information and it’s already factored into the price of everything. To some extent, it becomes the new baseline and what people expect.

Good job numbers this month? Yes, we know, it’s not a big deal—it happens every month. The better things are, the more difficult it becomes to be surprised by the upside and the more likely it becomes that the future will disappoint. If you’re a failing student, a B- would be cause for celebration, but if you’re a top performer, it would surely be a let down. Sometimes it’s not absolute performance, but relative performance that matters.

How Rates are Driving Investor Concerns

Lately, investors seem to be focusing on reasons why the good times may not continue and questioning whether their assumptions about the future may have been too rosy. In effect, expectations about the future are being adjusted downwards. A few key items seem to be driving most of the discussions, although there is never a shortage of potential risks to the markets.

The first concern is rising interest rates in the US and the ripple effects they’ll create around the world. The second is in regards to whether global growth will remain robust or whether factors will conspire to derail the world economy. In the tangled web of financial markets, it shouldn’t be surprising that these issues are deeply intertwined.

When the Great Recession occurred, the Federal Reserve acted quickly to reduce interest rates to effectively 0%. Low interest rates have a stimulative effect on the economy—they spur home and auto purchases that might not have been economically possible at higher rates, and they can make it cheaper for businesses that need loans to fund equipment purchases and expansion plans.

Low interest rates are not a panacea for all of society’s woes, however, and if not carefully managed by central banks, low interest rates can have unintended results, such as inflation and inappropriate risk-taking by investors. For example, investors who used to be able to earn a decent return buying ultra-safe US Treasury bonds are now forced to buy the debt of risky companies to earn the same amount.

Given the robust nature of the recent US economy, the Federal Reserve has been targeting higher interest rates to prevent the economy from overheating. In addition, it is restocking its toolkit for future economic hiccups—lowering interest rates is one of the Federal Reserve’s most effective tools for combating weak economic growth, which is hard to do if rates are already at rock-bottom levels.

The Effect of Rates on Growth

While raising interest rates is likely the appropriate measure to take, given the strong economic data, it can lead to slower growth—just like reducing interest rates encourages growth. It’s a tightrope act for the Fed for sure and whether the pace of its movements is too slow or fast will be debated for years to come. While academics sort through the nitty gritty, let’s focus on the salient reasons why rising interest rates are making headlines.

As mentioned, rising rates make it more difficult for consumers and businesses to access loans to fund their activities. So it slows down economic growth, but given the strength of the economy, these businesses and consumers should be able to withstand higher financing costs, right?

That’s the general consensus at least, but it still makes life harder and funds that could have been used to pay employees or buy equipment are now being used to fund interest payments. It may not prevent a strong company from getting a loan, but a company teetering on the edge may no longer have access to debt.

Interest Rates and the Global Market

Rising US interest rates also have a large effect on the global economy and can lead to increases in the interest rates of many other countries. If those countries’ economies are not strong enough to withstand higher rates, it can lead to problems—companies going bankrupt, workers losing jobs, increased inflation eating into wages.

Given the connected nature of the global economy, these problems can spill over into other countries and cause contagion—a fancy way of saying that a small manageable problem can quickly spiral into a larger, unmanageable one, if the problem isn’t handled in a timely and credible manner.

Other Factors Impacting the Market Downturn

Dealing with rising interest rates alone would be challenging enough, but there are a few other stories that investors are watching carefully. The recent tax cut put a lot more money back in the hands of businesses and consumers, but questions remain as to how much the tax cut stimulated the economy and whether those stimulative effects will last once the initial high has passed.

Rising US deficits, where the US government spends more money than it collects, also beget the question about what painful steps might be required to right the ship—reduced government spending, increased taxes, or a depreciated US dollar through inflation.

Lastly, trade war rhetoric and the enactment of protectionist measures seem to finally be weighing on future business prospects. The global economy is so connected that barriers raised in one area have the potential to affect areas halfway around the world.

Once thought to be resolved quickly, trade disagreements are becoming a real issue, raising costs for many firms and preventing other firms from expanding due to all of the uncertainty about what the future rules might be. None of these are pressing issues that will come to a head anytime soon, but all serve to reduce expectations about how great the future might be, which in turn causes prices to adjust.

Managing Risk in Today’s Market

Phew! If reading about the potential risks to the economy has made you nervous, then you might understand why other investors opted to sell their stocks in October. It doesn’t mean they’re right, it’s just what they did.

The focus of investors at any given moment helps inform what is driving market movements, and unfortunately, they’re currently focused on a lot of negative information. It’s important to understand the current risks to the market—and acknowledge there are risks you haven’t considered. Even more important is to keep these risks in context and remember that it’s all relative.

Whether risks exist is one thing, but whether the risks are getting riskier and whether you’re getting the necessary reward to accept the risks are the more important questions for investors. If you were comfortable with the risks in September, they’re still here for sure, but now you’re at least getting a 10% discount for accepting them.

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The opinions and analysis expressed here are those of Sam Nofzinger as of November 1, 2018. These views may change as economic, market and other conditions change. This information isn’t financial advice. Investment decisions should be based on specific financial needs, goals and risk appetite.
Advisory services offered through SoFi Wealth LLC, a registered investment advisor.
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