The news rocked the financial headlines: The Dow Jones industrial average plunged by a record 1,175 points on Monday, sending investors scrambling to check their portfolios to assess the damage.
And the biggest question on everyone’s mind: After what seemed like a never-ending market run-up, what exactly sent the markets spiraling down so fast?
To help explain what was behind the dramatic drop and what investors should do in light of it, we asked Northwestern Mutual experts Ron Joelson, chief investment officer, and Brent Schutte, chief investment strategist, to weigh in.
Q. Global economic data suggests major economies around the world are strong. So people are curious why the stock market plunged so far and so fast.
Ron: I think this is an overreaction to interest rates rising. The market got spooked. I think people are concerned that the higher rates we've seen with bonds in the Treasury markets will lead the Federal Reserve to put clamps on the economy. I don’t see any reason to believe that it will, but I think that’s probably what triggered the reaction in the market.
Brent: That strong economic data actually led people to believe that inflation may be on its way back. But the market itself wasn’t priced right for the reality that interest rates will rise and that we’ll have higher inflation. When traders realized those two things were likely to happen, that caused a reaction in the bond market last week. The change in the bond market then fed through to the stock market because the two are connected — when bond yields are low, stock prices tend to be higher, and visa versa. Then on Monday, the volatility in the stock and bond markets led some people who were making bets that volatility would remain low to sell stocks in order to cover their losses.
Q. Can you talk a little more about what it means to make bets on volatility?
Ron: There was a lot of money in the market that was invested based upon volatility remaining low. That included some exchange-traded funds (ETFs) and exchange-traded notes (ETNs) that bet against an index known as the VIX, which measures volatility in the market. For instance, with the VIX up more than 100% yesterday, one ETN in particular was down 94 percent, with much of the decline occurring in after-hours trading. People who had bought the ETN were trying to get out to lock in gains from when volatility was low. Yesterday afternoon, the sell-offs snowballed. In fact, the company that issued the ETN has announced that it will discontinue it on February 20th.
Brent: People were priced for inflation never coming back, that was the initial shock. Then the second shock was that people were priced for volatility to never return. Those factors just fed on each other. But that’s what a correction is. People are positioned incorrectly, so they have to change their position. It will eventually end. The economy is still strong and that will eventually take the markets higher because in the intermediate term, those two things are linked. But in the short term, they can deviate.
Q. Historically, is what happened Monday all that unusual?
Brent: No, but it’s odd because we haven't seen it in two years. And the pace of it yesterday was odd. I mean, it went from down 300 to down 1500 in the span of 10 minutes. Part of that, though, is because of automated trading. The markets today are reactionary. Very little money is traded based on work a human has done to look for value in the market. A lot of money is traded off computer models that just react.
“I think this is an overreaction to interest rates rising. The market got spooked.”
Q. Do you expect more big ups and downs like this in the coming months or years?
Brent: I think we’ll see more volatility, but I don’t think we’ll see a lot of moves as big as Monday’s. But in general, we have central banks around the world that are now starting to tighten policy. And historically, that means less liquidity, which typically leads to more volatility.
Ron: Volatility has been so low that recent events may feel a little strange, but I think we’re likely now just returning to what’s been normal historically.
Q. As an investor, should I be making changes?
Ron: I don’t think you should change your overall view. This might be a good opportunity to rebalance your portfolio. But overall the view is still pretty good from an economic perspective. These kinds of days can be very frustrating for day traders, those trying to make short-term gains. But I don’t think it should be frustrating if you are in the markets for the long term. You can take it in stride because you have an allocation that reflects your ability to take a certain amount of risk.
Brent: If you have a good plan, I don’t think you should change anything. This is a short-term market correction that you shouldn't react to. If you don’t need to sell, then you haven’t actually lost anything. This just underscores why it’s so important to have a long-term strategy that matches your need for access to your money. The only people who really lost money yesterday were those who actually had to sell.
The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss. The index referenced cannot be invested in directly. Investors should carefully consider their ability to invest during volatile periods in the market.