The Federal Reserve raised the Fed Funds Rate in September to its highest level in 10 years, but the stock market hardly reacted at all. And it will likely respond in a similar low-key fashion if the Fed raises rates again in December. But on a relatively quiet news day yesterday, the market plunged 800 points.
How can market participants be so laid back in the face of such newsworthy announcements and panicked just weeks later? Gregg Easterbrook coined the phrase “The Unified Field Theory of Creep” to describe how people anticipate events and holidays well in advance of what many would consider reasonable. We see Christmas trees in department stores on the day after Halloween and back-to-school sales when it seems summer has just begun. We hear rumblings of the next election the day after a new president is sworn into office. We simply anticipate what’s next and mentally and/or physically prepare for it early. The financial markets do much the same. They anticipate and mentally prepare.
Prior to the Fed raising rates in September, the market assigned a probability of 99% to that outcome. As a result, the financial markets gave a collective shrug when the Fed made its announcement. But, unlike Easterbrook’s theory, the markets cannot anticipate everything. While cooler heads prevailed in trade talks with China last May, discounting the possibility of a trade war, new tariffs announced in June caused the odds of a trade war to spike — resulting in a negative reaction from the markets. And yesterday, a handful of companies warned that trade issues may put a larger dent in corporate profits than expected, and the markets got spooked.
For the stock market to deliver the type of returns investors have come to expect, economic results and corporate earnings need to meet or exceed expectations, no matter how high or low those expectations may be. In early 2009, for example, automakers were failing, banks weren’t lending and unemployment was spiking. Market expectations plummeted. In hindsight, it was a great time to invest. The economy recovered quicker than anticipated, and stock prices soared as expectations were exceeded.
Currently, expectations are high for corporate earnings and the economy as a whole. Strong third quarter earnings and better-than-expected economic growth could cause stock prices to jump. But signs of weakness, like we saw yesterday, can push prices down. And as those third quarter results are coming in, the market already will be looking ahead to 2019 and creeping up on what might be coming next. Stay tuned…
Contact Scott Berry to learn more about this topic.
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