On Thursday, June 20, the stock market suffered a dramatic drop—its largest since last year’s election—following a significant decline the previous day. While this may leave you feeling unsettled, it’s important to look a little deeper and understand what is really happening.
Markets, like investors, hate uncertainty. Thus, when the Fed recently announced plans to begin tapering its stimulus program, it forced the financial markets to recognize that the government is dialing back its commitment to stabilize the economy. Of course, the Fed is pulling back because the economy is actually improving, but this news was enough to make investors nervous and, subsequently, the market fell.
As scary as market drops can be, it is important to keep things in perspective. At the same time markets have struggled lately, positive reports on the real economy have been released. Housing sales are up, consumer sentiment is up, and the leading economic indicators are up. This matters because the market ultimately depends on the real economy.
What is normal?
With a stronger real economy, we not only will have higher interest rates, we are supposed to have higher interest rates. The Fed’s proposed policy shift simply brings us back to normal—which is where we should want to be as soon as possible. For the Fed to publicly signal this shift is a sign that it thinks things are getting back to normal. This is good news.
The kind of volatility we’ve seen lately is also normal. The U.S. markets recently finished one of the longest runs on record without a significant correction. Based on history, the current volatility is not only normal, it is overdue.
A pullback like the one we’ve experienced in the markets is also healthy. Bubbles occur when markets get disconnected from reality. A pullback provides a very healthy pause for markets to reconnect with what’s actually happening. As is the case with so many things that are good for us, the volatility is necessary, even if a little unsettling in the short run.
Bumps on the road to recovery
It’s possible that we’ll see more volatility in the market as interest rates and other factors work toward stabilization. Concerns over the market should be tempered, however, by the ongoing strength of the real economy. The road back to normalcy may be rocky, but it will ultimately lead to a more sustainable environment for future market gains.