If you felt the shockwaves in the market yesterday, you’re certainly not alone. What happened and how does this affect you?
Let’s get some context. Yesterday, markets dropped about 3%, large cap US growth stocks as much as 4%. That’s a pretty big hit for one day. What are the factors behind that? Primarily, the Fed indicated that it will only cut rates maybe twice in 2025. In fact, the estimate is maybe an aggregate drop of a third of a percent between the two cuts.
That is next to nothing. Up until yesterday, markets in 2024 were up as much as 28%. Those markets are highly concentrated and very sensitive to any sort of negative news. So why did the Fed react the way it did? The thing to understand with the Fed is that it has a dual mandate. It’s rather unusual in the world. Most Federal Reserve type equivalents have a single mandate: to keep inflation under control. The Federal Reserve’s second mandate is actually to aim for and maintain full employment, which statistically, and by every econometric standard we already have today.
Unemployment is very low in the United States. The concern, therefore, is inflation rearing its ugly head in the next year. So, in 2025, the primary focus is likely to be controlling inflation without triggering unnecessary unemployment. If you’ve got time, read about the Smoot-Hawley Tariff Act. It’s actually pretty scary reading. Tariffs directly drive inflation. We’re also talking a lot about a weak dollar policy to “help” exports. The challenge with weak-dollar policy is exports become cheaper, imports become even more expensive, which triggers even more inflation.
For a number of reasons, we expect to have continued labor shortages, especially in skilled areas. Labor shortages drive inflation, so there’s a lot of reasons to fear inflation starting to climb. What’s very interesting to me is a lot of the policy that’s being discussed, and in fairness, ironically, the two parties have very similar economic policies. Both of them are focused on the manufacturing sector, which is interesting because though it’s very visible politically, we live in a service economy.
When we say service economy, we don’t just mean people working at McDonald’s. Consulting, technology, and even software could arguably be considered service-based. So, this is where our strengths are. We are in high value-added services, not manufacturing. Policies that boost manufacturing are maybe not best directed to our strengths. The severity of the market’s reaction to what frankly is unsurprising news suggests that there’s a lot of naive retail investors out there with trigger fingers.
We see a high level of naive investor activity usually when markets are extremely expensive as they are today. There have been a lot of opportunistic buying on the dip, and we would expect that. We would expect that some of these naive investors have given away their gains to other people at a better price. From an academic or an understanding perspective, we get the same lessons again and again. Markets overshoot. They overshoot short-term, they overshoot long-term, arguably the market overshot yesterday short-term on the downside.
The relevant question when we talk about overshooting in the marketplace is, “Are valuations today on a long-term overshoot or are they correct?” I would make the case, and it’s a pretty easy one to make, that when markets are valuations that have only been met prior to major corrections, that this is a market where nothing can afford to go wrong. If anything goes wrong, the valuations are wrong, and then the market will correct painfully.
What can you do about it?
This is why we build asset allocation models. Models that leave us with dry powder to take advantage of those corrections, but also with cushion so that we are not spanked as hard as the market is during those corrections. It’s frustrating when you’re in the middle of a very strong rally, maybe making a little less than that rally until the day after the correction when you’ve got more left over than everybody else. So, this is the point of the discipline of what we’re doing. Our job here is to improve risk-adjusted returns over time.
If you have any more questions about what’s going on or what you can do to protect yourself in this type of an environment, call me. Meanwhile, we wish you the best of investment success.