The shock of the 1,600 point decline in the Dow Jones Industrial Average Monday – the biggest ever one-day point drop in the index – was felt both in the FTSE 100 and the European markets this morning. The only surprise is that FTSE held up fairly well under the circumstances, falling 3.5% or 225 points Tuesday compared with DJIA’s 6% plunge during the previous trading day.
The fall in US stocks, though shocking, is probably the healthiest thing that has happened in the markets for a while. The DJIA has been powering ahead at an unnatural speed ever since Donald Trump was elected because US traders came to the conclusion that Trump will protect business above everything else.
US stocks moved up over 50% from where they traded in early 2016 in contrast to the local economy which has grown by 1.6% in 2016 and 3.2% in 2017. Now how do you spell ‘overheating’?
According to James Bateman, chief investment officer at Multi Asset at Fidelity International, “the tech-fuelled rally in the US had long lost any sense of reality in its valuations”.
Because of low interest rates and slow economic growth across the developed markets traders have been lulled into a false sense of security that the low volatility trading environment will last.
“In a world where the concept of a “correction” almost feels alien and where equities felt like an unstoppable one-way bet for a while, the normality of a setback can feel more painful,” says Bateman.
Holding this course as volatility eases won’t seem easy – but at this stage of the cycle, the traders who can keep their cool will be able use volatility in their favour.
Where to from here?
There are likely to be more corrections, particularly in the tech sector, before the market finds the new normal. The big unknown in the US is how the new Federal Reserve chair Jerome Powell will steer his ship. It seems near certain that US rates will be hiked in March but it is not clear if Jerome, chosen for his soft stance on interest rates, will try to slow down the pace of rate increase or opt for sharp hikes.
“As ever, the role of central bank chair is to walk a tightrope between prudence and sentiment. Either overtightening or a delay in tightening that would suggest a loss in confidence could spook equity markets and lead to a further leg down,” says Bateman.
He suggested buying equities on weakness into value areas of the market that have lagged in the recent momentum-driven rally. Stocks where dividend yields aren’t backed up by strong free cash flow and a solid balance sheet are probably best avoided.
However, after the plunge, index trading may be a good bet.