U.S. stocks had their worst September since 2002. Here’s what’s contributing to recent stock market volatility and what it may mean for long-term investors.
As we enter the final quarter of 2022, it appears investors are increasingly losing confidence in the Fed’s ability to rein in inflation without sending the economy into recession.
Indeed, after a strong July, U.S. stocks once again ended the quarter in bear market territory.
The Dow Jones Industrial Average finished the third quarter below 29,000 for the first time since November 2020, losing 8.8% in September alone. Meanwhile, the S&P 500 and Nasdaq Composite shed 9.3% and 10.5% last month, respectively.
It’s not unusual for stocks to experience a rough September, leaving some investors to wonder if seasonality may be partially to blame. At the same time, a strengthening U.S. dollar and climbing short-term Treasury yields remain problematic for stocks.
As investors brace for a potentially bumpy year-end, it may be helpful to understand why markets are behaving erratically and what this may mean for long-term investors.
THE SEPTEMBER EFFECT
There’s debate as to whether the September Effect exists—and if so, why. But historically, U.S. stocks have experienced relative weakness during the month of September.
In fact, since 1950, September has been the worst performing month of the year for the Dow Jones Industrial Average and S&P 500, according to the Stock Trader’s Almanac. Excluding last month, the S&P 500 has lost 7% or more in September 11 times, according to data going back to 1928.
Meanwhile, Dow Jones Market Data found that in Octobers that follow a 7% or greater decline in September, the S&P 500 rises 0.53% on average and sees a median gain of 1.81%. To put this into context, the average S&P 500 return for all Octobers is 0.47%, and the median return is 1.03%.
If history is a guide, seasonal patterns may help explain September’s decline and give investors a reason to be optimistic. Unfortunately, many experts believe the Fed’s aggressive tightening measures will overpower any seasonal anomalies.
THE FED’S ROLE IN RECENT STOCK MARKET VOLATILITY
Indeed, numerous factors often contribute to stock market volatility. Yet many believe the Fed’s aggressive efforts to tame inflation are largely responsible for the sharp downturn in financial markets.
In just six months, the Fed has pushed its near-zero benchmark rate to a target of at least 3%. Meanwhile, the central bank also initiated a plan to unwind its $8.8 trillion balance sheet via a process called quantitative tightening (QT). (Rather than reinvesting proceeds from the securities it has on its books, the Fed will allow them to roll off each month.)
Unfortunately, the Fed’s attempts to fight inflation by boosting short-term rates has implications for both stocks and bonds. In September, the 10-year Treasury yield topped 4% for the first time since 2008. Higher bond yields can make stocks appear less attractive on a relative basis, prompting investors to move their funds away from risky assets.
At the same time, elevated bond yields may be an indication that the market is pricing in tighter monetary policy for longer. In other words, investors are realizing that it may take longer to cure inflation than they or the Fed originally expected. And this, in turn, creates more uncertainty for the U.S. economy.
WHY IS THE YIELD CURVE IMPORTANT?
Alongside a spike in stock market volatility, short-term Treasury yields recently hit their highest levels in more than a decade and briefly exceeded their longer-term counterparts. This is significant because an inverted yield curve has accurately predicted the last 10 economic recessions.
The yield curve is the difference in interest rates between short-term and long-term Treasury bonds. In a normal economic environment, short-term interest rates are lower than longer-term interest rates, resulting in a yield curve that slopes upward.
Intuitively, this makes sense. Owning a bond essentially means you’re lending money to the issuer—in this case, the U.S. government—for a set amount of time. At the end of the period, you expect to receive your money back with interest. As the lending period extends, you expect to be compensated accordingly to make up for the additional risk you assume in the meantime.
An inversion in the yield curve occurs when yields on longer-term bonds fall below short-term yields. Put differently, investors earn a higher rate on their short-term bonds than on their longer-term bonds. And since short-term bonds are relatively low-risk, investors are more likely to pour funds into Treasuries than stocks when rates on short-term bonds increase.
Most economists agree that an inverted yield curve doesn’t cause recessions. However, it does tend to reflect negative investor sentiment about future economic growth, making it a popular leading indicator.
Furthermore, banks are less incentivized to make long-term loans when short-term interest rates are high. Therefore, economic growth often slows when banks pull back on lending.
THE U.S. DOLLAR AND STOCK MARKET VOLATILITY
Surprisingly, a strengthening U.S. dollar has also contributed to recent stock market volatility. In fact, the U.S. Dollar Index has increased nearly 20% since the start of the year and is near its highest level in almost two decades.
Indeed, a strong dollar can be viewed positively for many reasons. For example, it’s an indication that the U.S. economy is doing better than other economies. Although inflation is high, the U.S. labor market is strong, and other areas of the economy remain resilient.
Meanwhile, rising Treasury bond yields are attracting investor dollars from all over the world. Since other central banks have been less aggressive than the Fed in raising rates, foreign government bond yields haven’t jumped as dramatically as they have in the U.S. And when investors exchange their currencies for dollars to buy U.S. Treasury bonds, this further strengthens the U.S. dollar.
For travelers, a strong U.S. dollar makes it relatively less expensive to travel abroad. In addition, a strong dollar helps consumers by generally offsetting prices on imports and commodities.
But there’s a flip side to a strong dollar, as well. A soaring U.S. dollar effectively reduces earnings for multinational companies that generate sales overseas. When these companies translate foreign sales into a stronger dollar, they report fewer dollars in earnings.
As a result, Wall Street analysts are warning of a potentially disappointing earnings season from U.S. stocks. And since the dollar is the world’s reserve currency, the global economy is likely to suffer as food, energy, and debt become increasingly expensive to economies outside the U.S. Both factors are likely to affect stock market volatility in the near-term.
WHAT DOES THE FUTURE HOLD FOR LONG-TERM INVESTORS?
No one can predict with certainty what the future holds. As the Fed works to combat inflation without sending the U.S. into recession, the fate of the global economy hangs in the balance.
One thing we do know is that markets tend to dislike uncertainty. Thus, investors are likely to see heightened stock market volatility for the time being.
It can be difficult to watch your investments fluctuate in value. Yet it’s important not to lose sight of your long-term goals. Remember: your investment plan is designed to withstand periods of volatility and temporary losses.
We believe the best approach is to stay the course, especially when it feels most uncomfortable to do so. As always, we’re here to help if you have any questions or concerns.
If you don’t have a financial plan, a trusted financial advisor can help you develop a comprehensive plan for your money. To learn more about how we help our clients and see if we may be a good fit, please contact us. We’d love to hear from you.