When markets wobble, stick to the facts

The human brain responds more to feelings than facts. This can get in the way of good investment decisions. So, a sensible thing to do after the week we’ve just endured is to park our emotions and go in search of the numbers.

Keeping calm helps when markets are falling. It is also essential when markets are volatile in both directions, as I suspect will be the case for the next 90 days. That is the period for which Donald Trump has suspended (not cancelled, mind) many of the swingeing tariffs unveiled last week. It will be a three-month period in which every hint, social media post and other market moving nuance will be scrutinised by investors. Maintaining a clear head will be key.

Step one in navigating a stock market correction is to put it in a historical perspective and decide what is really going on. How do the current market moves compare with similar episodes in the past? First, let’s look at where we stood before this week’s explosive rally after the tariff suspension. At that point, shares had fallen well into correction territory and the big question was how far they would go before finding a floor.

Between the financial crisis and the latest correction, there had been four drops that met the usual definition of a bear market - a 20% decline. The first, in 2011, saw a 22% fall in five months. The next, in 2018, was a 20% drop in 11 months. The start of the pandemic in 2020 was deeper and faster - a 33% fall in just over a month. In 2022 the MSCI World index fell 27% from January to October.

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So, the latest fall of 16% from the February high to Tuesday’s low was notable for the pace of the decline - which brought back memories for some of us of the 1987 crash and the 1998 collapse of the Long-Term Capital Management hedge fund - but not yet for its depth. Using closing prices, the drop remained in correction rather than bear market territory.

Step two is ascertaining what caused the fall. This is not always simple. The current slump has had multiple triggers. It began with a rotation out of the US in response to excessive valuations. But latterly the focus shifted to growth and inflation fears, exacerbated by erratic and (the market concluded rightly) illogical and unsustainable policy making. There are echoes of previous corrections here - a reminder that market history never repeats but often rhymes.

The third part of the classification process is to look at where the market pain is being felt. Share prices can fall for a whole host of reasons and by themselves tell you little. Other measures can convey more useful information. A stumble in the corporate bond market, for example, with investors demanding an increasingly higher yield from companies than governments, can be a better signal of distress in the real economy than a sentiment-driven stock market wobble.

Elsewhere, if traditional havens like government bonds fall when you might otherwise expect a flight to safety, this can be a sign that over-leveraged investors are struggling to lay their hands on cash - a liquidity red flag. Same story with gold, which usually rises on uncertainty but can fall if overstretched investors are selling what they can rather than what they would choose to.

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We know that shares have fallen hard and fast in the past week. What about the other measures? Corporate bond spreads have widened since the start of the year, but they have only returned to the historical average. More worryingly, Monday saw the fastest rise in the yield on the 30-year US Treasury bond since the start of the pandemic. This has raised the possibility that big holders of Treasuries such as the Chinese are weaponizing their holdings, deliberately selling to destabilise the financial system and force a policy U-turn on the US. Finally, gold fell for four consecutive sessions from its all-time high from last Wednesday to Monday. There are certainly signs of stress, but they are not yet flashing red.

The final piece of context is whether or not we are heading towards a recession. This matters because bear markets tend to be more severe and to last longer if accompanied by a recession than if they are triggered by some kind of one-off shock that does not lead to an economic downturn. The current market turmoil feels more like the event-driven type of correction. Activity is slowing but it’s not yet clear if we face a full-blown recession. Our figures suggest a 40% chance but a slightly higher likelihood of stagflation - sluggish growth coupled with persistent inflation.

The next job for someone deciding whether to jump back into the market or stay on the sidelines is to check in on fund flows, earnings, and valuations - the fundamental investment measures. So, how severe has the selling pressure become? One measure of this is the percentage of companies that are now trading below their recent average price. Typically, investors look at this over a 200-day period. Only a quarter of big US stocks are now above that 200-day moving average price - in 2018, this fell to 16%, 12% in 2022 and just 3% when Covid struck. So, shares were starting to look oversold before this week’s rally, but they were not yet in a clear buy zone.

When it comes to the most commonly used valuation measure, which compares share prices to earnings, it’s another case of ‘move on, nothing to see’. The ratio of price to earnings in the US has fallen from 26 to 21 which means the market is no longer expensive but not obviously cheap either. With the first quarter earnings season due to kick off tomorrow, the focus will be on just how long profits can keep growing in the face of the tariff squeeze. Earnings are still forecast to grow about 10% year on year. Frankly, that would be a good result. I expect some cautious commentary from companies over the next few weeks. It is worth remembering that the tariff situation is still considerably worse than it was just over a week ago. Recession risks may have eased slightly but there are plenty of growth headwinds.

The past week has been a cold shower for investors, but it really only takes markets back to where they stood shortly before the architect of all this volatility won back the keys to the White House in November. It’s worth noting that while the MSCI World index fell to 16% below its recent peak it was still 36% above its level in October 2022 at this week’s low point.

To have benefited from that two-and-a-half-year gain, you would have had to be fully invested at a time when the market had just fallen by more than a quarter from its prior peak and sentiment was very weak. To do that would have required a focus on facts not feelings, and the same holds true today.

This article is adapted from a column originally published in The Telegraph.

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