Teachable Moment: Questions and answers after a week of market volatility

As U.S. stock markets oscillate through a week of volatile ups and downs, anyone with money in the markets likely will have questions about the long-term health of their investments and the fundamental forces underpinning the economy.

For answers, The Spokesman-Review reached out to two Gonzaga University professors: Danielle Xu, professor of finance and Mozilo Chair of Business Administration; and Kent Hickman, professor of finance. Their joint responses are below.

Falling markets and volatile stocks, yet all indicators show a strong economy on solid footing. How can this be? Should we be concerned about an economic downturn?

The market has experienced big swings since last Friday, the first coming after the January job market data showed that wages grew at a faster speed than expected. This raised concerns about higher inflation rates down the road, as well as concerns that the Fed may respond by raising interest rates.

A hike in interest rates would lead to higher financing costs for businesses, which, in turn, would slow economic growth.

In addition, the bond market will be more attractive to investors after an interest rate hike.

This past Monday also contributed to the uncertainty about the policies of the new Federal Reserve chairman, Jerome Powell, in regard to monetary policy under his reign.

Since the 2008-09 recession, the market has been accustomed to a very accommodative Fed. However, recent data points – along with a sharp move in the 10-year Treasury – indicate that investors anticipate higher rates sooner.

In addition, concerns about the government deficits and potential shutdown, debt-ceiling negotiations and a pre-emptive military strike against North Korea together caused uneasiness and volatility in the stock market.

The uncertainty index, or fear factor of the stock market, has tripled during the past two weeks. The market has yet to absorb (or price in) all these uncertainties, and one result is increased volatility.

According to key economic indicators, the U.S. economic outlook is healthy. In January, the unemployment rate hit a 17-year low of 4.1 percent, average hourly earnings rose 2.9 percent from a year earlier, the GDP growth rate is expected to remain between 2 percent and 3 percent, the target inflation rate will be around 2 percent and businesses continue to expand, fueled in part by tax cuts. There is little reason to be concerned about an economic downturn in the short term.

Many observers speak of overvalued stocks and how they have driven the market ever higher. Some mention a “bubble,” which automatically brings to mind the devastating impact of the housing bubble of the past decade and the recession that followed. Should we be concerned now?

Both the S&P 500 price earnings ratio (PER) of 25 and the inflation adjusted PER (known as CAPE ratio) of 32 are well above their historical averages, indicating stocks are very pricey. However, since bubbles are created by speculation and the underlying business economy appears strong, it is not clear that equities are overvalued.

What should those with investments be focusing on now?

It depends. If you are a long-term investor or are saving for a retirement that won’t come for 10 years or more, you don’t need to make any changes if you already have a well-diversified portfolio. For those who are approaching retirement, you may need to adjust the allocation between bonds and stocks.

For short-term investors, you may want to watch the market closely to take the profits so you remain comfortable with your portfolio’s risk level. Bull markets do not last forever … but for longer-term investors, you can ride out the market’s ups and downs.

The past few days have seen the market move toward “correction” territory. Is this a surprise?

Over the last 40 years, stocks have seen a decline of 10 percent or more in two-thirds of those years. In most cases, stocks ended the year in positive territory. Pullbacks (decline of 5 percent to 10 percent) and corrections are a normal part of a well-functioning market. As the market (S&P 500) has gone up for 13 consecutive months as of this January, along with record low volatility, it is not surprising to see a pullback, like what happened this week.

If we could forecast the market, we would be super rich (and we are not!). Be cautious of those who claim they can accurately answer questions like this one. Stick to your investment strategy, one that is based on your objectives, your holding period, your risk tolerance and diversification.

Can the Dow remain at 22,000 or higher – and keep growing – indefinitely?

In the long run, it will grow above 22,000 if U.S. and global economic growth is on the right track. It is challenging to predict the market in the short run. Nothing can keep growing indefinitely. We will experience business cycles.

What can we expect to see with the market in the next week, month or six months in light of this past week?

The market will be different from what we have seen during the past 15 months. There will be some corrections down the road, which can be healthy for the stock market and the economy because it may help us avoid the kind of speculative bubble that was discussed above.

What should I do with my investments if I’m just starting out? Middle-aged? Ready for retirement?

For the younger generation, it is a good time to start building up a long-term retirement plan, where investing in the overall stock market (for example, low-cost index funds) will provide decent returns.

If you are approaching retirement, it will be challenging to keep all your investments in the stock market. The bond market will provide a safety net.

The general advice is that as you get closer to retirement, allocate more investments to safer assets. The target-date funds provide a mix of stocks and bonds depending on your retirement horizon. They could be a useful resource.

But keep in mind that each individual investor is different in terms of goals and risk tolerance. So it is important for that investor to choose an asset allocation that takes the right amount of risk so that he or she can stay invested for the long term and not move in and out of the market because of short-term aberrations.

What are the different ways today, a Friday, could go? Should investors be concerned if markets have not fully recovered?

As a long-term investor, you should not fret on the volatilities that are triggered by temporary news. As long as the U.S. and global economic fundamentals remain strong, the long-run prognosis should be good.

It is hard to predict where the market goes from here. There is always news that might move the market on Monday, such as an unexpectedly high inflation report or some unanticipated event. But at this point, there is no reason to believe that the recent volatility is going to lead to a bear market.

This article was written in collaboration with the School of Business Administration at Gonzaga University.