Stock Market Volatility: Recession Worries Return

Investors experiencing a brief bout of euphoria following the Federal Reserve’s aggressive three-quarter-point interest rate hike Wednesday tumbled back to Earth on Thursday, dragging U.S. stocks with them, as recession concerns pushed back to the fore. The benchmark S&P 500^® Index fell more than 3%, leaving it beyond the 20% border commonly accepted as bear market territory, while the tech-focused NASDAQ dropped more than 4% and the small-firm-oriented Russell 2000 slipped nearly 5%.

Despite Chairman Jerome Powell’s suggestion at the Fed’s post-meeting press conference Wednesday that three-quarter-point rate increases were unlikely to be the norm going forward, concerns about a possible recession remain high. Data released Thursday showed why: Housing starts fell sharply in May, while jobless claims ticked up. Meanwhile, layoff announcements have become more frequent.

With Thursday’s losses, the S&P 500 is now down nearly 24% from its high in January. The NASDAQ and Russell 2000 are down more than 30% from their recent highs. Risk aversion was especially strong in the crypto market. Bitcoin has fallen nearly 70% from its recent peak.  

Schwab recommends that investors stay disciplined. For stock investors, that means taking a sector-neutral approach and focusing on high-quality factors such as strong balance sheets, high free-cash-flow yield, and positive forward earnings revisions. Investors should also periodically rebalance their portfolios to maintain their strategic long-term allocations in the face of rapidly shifting markets. For bond investors, that means focusing on higher-quality bonds like Treasuries, certificates of deposit (CDs), and investment-grade municipal and corporate bonds. They should tread carefully around high-yield bonds and bank loans that could face risks as rising interest rates pressure corporate borrowing costs. 

U.S. stocks: Volatility likely to persist

• Stocks have priced in much of the current economic weakness and are getting closer to pricing in both a recession and significant slowdown in profit growth.
• While the market has enjoyed a few sharp rallies this year, the overall trend remains downward. In the near term, we believe any coming rallies will continue to be short-lived.

Bonds: Yields volatile

• Treasury yields have fluctuated all week as investors considered actual and potential changes to Fed policy. Where yields go from here will likely depend on the inflation outlook and how aggressive the Fed’s response will need to be. Given how stubbornly high inflation has been, Treasury yields of all maturities could drift higher. 
• The Fed’s number one goal right now is to fight inflation, and further stock market declines are unlikely to slow its aggressive pace of hikes. Markets are pricing in half-percentage-point rate hikes (or more) at the Fed’s next four meetings. The federal funds target rate is expected to rise to 3.4% by year-end, up considerably from what was expected just a few days ago. Based on the Fed’s median projection, the federal funds rate could rise to 3.75% next year.
• The yield curve is flirting with inversion. After briefly dipping below zero in each of the first three days of this week, the 2-year/10-year Treasury curve steepened on Thursday as short-term yields fell while the 10-year yield was mostly unchanged. As the Fed continues to hike rates, we expect the yield curve to invert on a more sustained basis as tighter financial conditions result in slower economic growth.

Global stocks: Concerns growing

• Central banks globally are moving quickly to fight inflation, with central bankers in the United States, Canada, and Australia all opting for bigger rate increases. Those that haven’t followed suit—including the European Central Bank and Bank of England—are indicating future hikes may be larger.  
• International stocks benefitted from a fall in the U.S. dollar, as monetary policy in the rest of the world is becoming more aggressive.  A weakening in the dollar could benefit international stocks.
• Markets are likely to stay volatile, but that doesn’t mean investors have to act. Rather than make a bet one way or another, it can make sense to stick to strategic asset allocation weightings and let the broad diversification of the allocation help manage the volatility. Once volatility subsides, investors who are underweight on international stocks may want to shore up their allocation, as we believe it may be the winner in the next cycle.

Trading takeaways: Bearish downtrends return

• The bearish price action in stocks appears to be accelerating as all the major U.S. indexes hit new 52-week lows Thursday. Other technicals remain bearish: The Relative Strength Indicator has yet to provide a near-term oversold signal (a reading below 30) or a positive divergence signal (lower price/higher RSI reading). The Dow Jones Transportation Index closed at a 15-month low. 
• Volatility remains elevated but isn’t signaling “panic” yet. The Cboe Volatility Index is essentially unchanged this week, even with today’s 3% sell-off in the S&P 500. A breakout above the top end of the VIX’s 20-36 2022 trading range could suggest “panic selling” sentiment. At its current level of 33, the VIX is implying daily moves in the S&P 500 index of 63 points in either direction.
• Given current volatility expectations, option premiums are historically high, making downside risk protection relatively expensive. Traders should consider offsetting hedging expenses by employing multi-leg strategies, such as collars or vertical spreads.
• Equity traders should consider reducing their average share and dollar amounts per trade. While equities could experience sharp bounce-backs at any time, large downside moves may be just as likely. With the major indexes in or nearing bear markets, the risk of margin maintenance calls increases accordingly.

What should long-term investors do now?

Market volatility is unsettling, but historically not unusual. If you’ve built an appropriately diversified portfolio that matches your time horizon and risk tolerance, it’s likely the recent market drop will be a mere blip in your long-term investing plan.

However, it can be hard to do nothing when markets are rough. Here are some things to consider:

• Bear markets don’t last. The Schwab Center for Financial Research looked at both bull and bear markets for the S&P 500 going back to the late ’60s and found that the average bull ran for about six years, delivering an average cumulative return of over 200%. The average bear market lasted roughly 15 months, delivering an average cumulative loss of 38.4%. The longest of the bears was just over two and a half years—and was followed by a nearly five-year bull run. The shortest was the pandemic-fueled bear market in early 2020, which lasted a mere 33 days.
• Resist the urge to sell unless your financial situation warrants it. It’s difficult to time a perfect re-entry into the market. Market rebounds tend to be front-loaded. Missing those key days can have a big impact on performance. A diversified portfolio can help reduce the pain of volatility.
• Don’t try to time the markets. It’s nearly impossible. Time in the market is what matters. While staying the course and continuing to invest even when markets dip may be hard on your nerves, it can be healthier for your portfolio and can result in greater accumulated wealth over time.