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Wall Street to Your Street

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What's Behind The Drop In Stocks?

After suffering the biggest stock market drop since 2011 on Monday, February 5, the stock market bounced into positive territory Tuesday.

The drop on Monday was the largest stock market decline since 2011. The Dow Jones Industrial Average dropped more than 1,100 points. The S&P 500® was down 7.19% from its January 26 peak through the close of Investment professionals talkingtrading Monday – essentially wiping out all of the stock market gains since the start of the year.

Although we believe that the economy is still solid, we expect market volatility to continue. The market sell-off was not unexpected considering that the market had reached the highest valuation since 2004, with a forward price earnings (P/E) level of over 18.1

Exhibit 1After the Monday correction, the forward PE ratio dropped to about 16.5, which is considered a more appropriate valuation level.

With solid economic growth, healthy corporate earnings that are getting a boost from the tax legislation and still relatively low interest rates, we do not expect that this is the start of a major downturn. Although we are late in the bull market cycle, we don’t think this is the end of the cycle.

Trading Trends Spark Volatility

Exhibit 2The most recent declines in the market have been exacerbated by technical developments in the futures and options market as various inverse and leveraged exchange traded funds (ETF) have had to deal with the extraordinarily sharp spike in market volatility.

In short, large ETFs that make investments based on the prospects for market volatility (specifically those that bet on continued low volatility) were driven down by the sudden market volatility of the past few days. The large losses suffered by these ETFs had significant ramifications for the Exhibit 3underlying equity market – essentially driving the market down even further.

But these types of ETFs are just the most visible public impact of the esoteric strategies that have gone awry. There is also significant exposure to these and similar strategies in certain private asset pools. We do not trade in, nor condone, these very complex and high risk products.

Investor Perspective

The recent sharp market decline, coupled with higher volatility, can feel much more pronounced to investors given the smooth, sustained rise of the market over the past year. We believe that although disconcerting, this pull back is actually healthy in that it takes some of the extreme sentiment and unrealistic expectations out of the market – while driving stock valuations down to a more reasonable level.

In fact, we have been saying for over a year that stock valuations are high and interest rates abnormally low. Equity markets were due for a correction since stock valuations reached record levels at the end of January. It had been 403 days since a 5% correction, which is a record.2

As such, we have been very modestly underweight equities and cautious about rising interest rates. It would not be surprising if equity markets push lower in the near term. However, as noted, we believe the underpinnings of the economy remain solid.

As long term investors, we welcome the opportunity to initiate or add to solid investment opportunities when markets decline.

Dealing with Volatility

For investors, volatility is often part of the game. To learn how to deal with the volatility, see:

Don’t Fear Volatility: Capitalize on It through Dollar Cost Averaging

The Inevitability of Volatility

Part of Thrivent Financial's mission is to help people make wise financial decisions. If you found this article helpful, please .