Looking Beyond the Equity Market Sell-Off

Global stocks have fallen by about 9% so far this month, through the October 24 market close. International and emerging-market stocks led the declines earlier in the month, but US stocks have now followed. By Wednesday’s close, US stocks had also declined by nearly 9%, with high-growth technology stocks dragging the market down. Stocks showed signs of a rebound midway through Thursday’s session, but are clearly still unsettled.

Much of the mayhem is being driven by concerns about corporate profits. Heightened uncertainty around the pace of expected earnings growth has triggered a recalibration of equity valuations that is still unfolding—and will probably continue to fuel volatility. Still, it’s important to note that US earnings growth is decelerating—not declining—and the sell-off will create more attractive valuations globally.

Three Culprits Behind the Recent Market Volatility

As we see it, this week’s declines have been driven by three main concerns:

1) The recent rapid rise in interest rates. The 10-Year US Treasury yield rose from 2.8% in mid-August to 3.2% on Wednesday. While a 40 basis point move in six weeks isn’t uncommon, it is a large move in a short period of time that became worrisome for many investors.

2) Market leadership sell-off. In recent years, technology stocks led the US market—particularly the high-growth FAANG stocks (Facebook, Amazon, Apple, Netflix and Google). This subgroup of stocks has dragged the market lower over the last few days as investors took profits. When market leaders are sold indiscriminately, all sectors feel the pain.

3) Trade-related warnings on earnings. Companies in multiple sectors have reported concerns about the negative impact of trade tensions on forward earnings. Disappointing quarterly results continued to stoke investors’ jitters over future growth in corporate profits—especially in the US.

How Extreme Is the Sell-Off?

With three big concerns feeding investor anxieties, global equities have fallen by 3% since the start of this week (as of Wednesday), while the S&P 500 Index has dropped by 4%. Declines of this size aren’t common—but they’re also not extraordinary; it just feels worse because markets have been extremely calm for years.

On Wednesday, the VIX index of US market volatility moved up to 22. That’s slightly above its long-term average, but nowhere near the 37 mark that it reached earlier this year during the February–March sell-off. This upward move, however, does suggest that markets may stay volatile for a while, as we’ve anticipated.

Sell-offs within a calendar year are also typical. Since 1980, the S&P 500’s median intra-year sell-off is 10%. Yet, over that same 38-year period, the index finished the year in negative territory in only six years. We’re not suggesting that stocks will finish in positive ground this year, but it helps to remember that intra-year pullbacks are actually normal features of market activity.

Fundamentals Are Still Healthy

When volatility spikes, it’s natural to worry about underlying market conditions. In many markets, fundamentals remain in good shape, though not as good as they were earlier this year.

On the economic front, our economists have modestly lowered growth expectations because of issues related to a rising US dollar, higher US interest rates and trade uncertainties. The US economy remains quite strong, and we don’t see signs of a recession on the horizon that could cause a prolonged equity market slump. Although other major economies are not as robust, growth is generally continuing.

Markets and economies are linked over the long term, but they can become detached over the short term. This type of divergence often happens when investor uncertainty and sentiment dominates market activity, as we’ve seen recently.

What Should Investors Think About?

Keep your investment strategy on track. October’s equity-market pitfalls have highlighted some of the challenges of keeping a portfolio on track through tough times. But even though short-term market conditions can put emotions to the test, there’s no substitute for working with a financial professional to design and maintain an appropriate portfolio allocation across asset classes and geographies, and to rebalance exposures in the case of extreme asset-class movements.

Avoid pulling the plug on equities. Stocks are a vital component in well-diversified portfolios—and in fact, they’ve posted better returns than we’ve expected in recent years, so it isn’t unexpected that stocks will give back some ground from time to time. In our view, equities still offer good long-term opportunities. And it’s almost impossible to time market turns, so reducing an equity allocation could lock in losses if the market rebounds.

Prepare for market volatility to stick around. Staying the course doesn’t mean ignoring the realities of occasional market turbulence—and volatility isn’t likely to go away anytime soon. Staying active in equities allows portfolios to manage exposures to sectors and market segments and focus on quality companies with strong cash flows trading at attractive valuations. This can help cushion equity portfolios against downside while capturing upside.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.