Market Volatility: Schwab's Quick Take

by Schwab Center for Financial Research

U.S. and global stocks fell sharply Friday amid spiking fears about a new COVID variant, named Omicron, emanating from South Africa, where it’s spreading quickly. The S&P 500, Dow Jones Industrial Average and Nasdaq Composite indices closed down more than 2%, while the Russell 2000 fell nearly 4%.

U.S. stocks: Major indices dropped sharply

Adding salt to today’s wound was the news about a lower efficacy of Merck’s COVID-19 pill, which reportedly reduces the risk of hospitalization/death among adults with mild/moderate virus by 30%, down from the original expectation of 48%.

Even before today’s selloff, market breadth had been deteriorating (market breadth reflects the number of stocks with rising prices vs. declining prices) and investor sentiment had been very optimistic, which can be a contrarian indicator. Sentiment is key to watch in the near term to see if today’s decline puts a dent in the recent signs of euphoria, especially if market breadth continues to deteriorate.

Low-quality and/or speculative market segments were hit even harder than the major averages. Many speculative trades have had (or remain in) bear-market-level drawdowns from year-to-date highs, as the bias toward higher-quality companies has continued to strengthen.

Global stocks: Policymaker, consumer responses will be key

The economic impact of any new COVID-19 waves will likely depend on both policymaker and consumer responses. We’ve seen different approaches (e.g., the U.K. and U.S. are less likely to add restrictions versus China’s “zero tolerance” policy), as well as consumer behavior (either in reduced spending, hesitancy to return to work, and/or masking and social distancing).

The COVID-19 toolbox has expanded relative to prior waves, including oral pills to treat infections, which could result in a shorter and/or smaller economic impact. However, supply chains are already stressed, and new virus waves could extend disruption length.

Bonds: Safe-haven buying lifts Treasury prices, lowers yields

Yields fell sharply on speculation the Federal Reserve will be less likely to raise interest rates if a renewed virus outbreak should slow economic activity. The 10-year Treasury yield fell to less than 1.5%, after rising as high as 1.67% last week. Expectations for stronger growth and continued high inflation reversed quickly, as commodity prices and risk assets sold off. Treasuries saw inflows on safe-haven buying.

The market had been pricing in an increased pace of tapering by the Fed and two to three rate hikes starting in June 2022, due to rising inflation pressures. News of the new variant has pushed that back to one to two rate hikes, starting in September. Similarly, rate hike expectations in the U.K. have fallen. The Fed and Bank of England both meet in the next two weeks. At the Fed meeting December 14-15, we expect a more cautious approach to tightening policy in case of a slowdown in economic activity due to the virus. Between now and the next meeting, expect markets to be volatile.

Short- and longer-term bonds are likely to remain volatile. Longer-term bond prices are generally more sensitive to changes in growth and inflation expectations, while short-term bonds reflect expectations about the path of Fed policy. We suggest investors continue to target a shorter-than-average benchmark duration. Bond ladders and barbells can be good strategies to consider in this environment.

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. Given what has been happening recently, consider a few of our investing principles:

• Establish a financial plan. It’s easier to ride out volatility if you have a financial plan based on your goals and investing time horizon. By keeping your eye on the finish line, you’ll be less likely to panic and sell when prices are down.

• 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 result in greater accumulated wealth over time.
• Build a diversified portfolio based on your tolerance for risk. It’s important to know your comfort level with temporary losses. Sometimes a market drop serves as a wake-up call that you’re not as comfortable with losses as you thought you were, or that a portfolio you assumed was appropriately diversified in fact isn’t. Schwab clients can log in and use the Schwab Portfolio Checkup tool to quickly assess whether their portfolio is still in balance with their target asset allocation. If you’re not a client, or haven’t yet established an investment plan, our investor profile questionnaire can help you determine your profile and match it to an appropriate target asset allocation.

• Active equity traders should consider reducing average share size and dollar amounts per trade, and exercise caution before buying the current dip. It is far too early to predict the degree to which the Omicron variant might spread to other parts of the world, or the economic impact it might impart. While some bargain-hunting may quickly emerge, traders should be patient and consider scaling-in to any new equity exposure.

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