Market Volatility: Schwab’s Quick Take

U.S. stocks fell Tuesday on persistent concerns over the debt ceiling, along with a continued increase in Treasury yields. The S&P 500 closed down 2%, the Nasdaq fell 2.8%, and the Russell 2000 fell 2.3%.

All equity sectors except Energy declined. Growth-oriented sectors struggled most, with Information Technology and Communication Services falling 3% and 2.8%, respectively. The relatively fast increase in yields over the past week has put pressure on higher-valuation sectors—namely, Information Technology, Communication Services, and Consumer Discretionary, which make up more than half of the S&P 500’s value by market cap. The Energy sector has fared relatively well, benefiting from the recent strength in oil and gas prices.

U.S. stocks: Stocks were already churning below the surface

Even before today’s selloff, more than 80% of the S&P 500’s constituent stocks had declined by at least 10% from their highs this year. Despite relatively little volatility at the index level, shifts at the sector level have been swift and frequent. The constant leadership reversals between growth-oriented sectors like Information Technology and Communication Services and value-oriented sectors like Energy and Financials have contributed to weakness.

Low-quality, speculative assets have not been a haven. The many micro bubbles that were pricked in February—unprofitable tech companies, newer initial public offerings (IPOs), special purpose acquisition companies (SPACs), etc.—have continued to weaken. Most speculative trades remain in correction or bear-market territory, as the bias toward higher-quality companies has continued to strengthen.

Global stocks: Inflation concern is growing

Bond yields are rising globally as monetary policy becomes less accommodative amid continued upward pressure on inflation. The Bank of England’s comments last week about the potential for inflation to be more persistent may have been a wake-up call.

Rising energy prices could crimp consumer spending and factory production. Better global growth prospects along with environmental regulations hindering capital investment and electricity production are pushing prices up. Typically higher prices reduce demand and boost supply, acting as a built-in solution.

International stocks tend to outperform during periods of higher global growth and inflation. A lower weight in technology and higher weight in economically sensitive sectors could help relative performance, but a strengthening U.S. dollar could be a headwind.

Bonds: Fed expected to announce tapering soon

Treasury yields are rising on speculation that the Federal Reserve soon will announce plans to taper its bond-buying. The 10-year Treasury yield has risen nearly 25 basis points, to the highest level since late June 2021, after the Fed announced last week that it was likely to announce tapering soon.

Expectations for when the Fed will begin to raise the short-term federal funds rate target have been pulled forward. The updated Federal Reserve “dot plot” from the September meeting showed that Fed officials were equally split on whether the first rate hike should occur in 2022 or 2023. Previously, projections indicated no hikes through the end of 2022. However, despite concerns that the Fed is pulling back on its bond-buying program and may raise rates sooner than expected, policy is still accommodative. Growth and inflation expectations may have peaked, but are likely to settle at an above-average level. Higher growth and inflation expectations are a catalyst for higher long-term yields.

While growth expectations may have peaked, the level of growth still remains high. In addition, concerns are growing that inflation may not be transitory. We see the potential for yields to move higher, due more to inflation becoming “stickier” versus the Fed reducing the pace of its bond buying program.

Prices for longer-term bonds are generally more sensitive to changes in interest rates relative to shorter-term bonds, and as a result may experience greater declines in price. We suggest investors target a shorter-than-average benchmark duration, which can help mitigate the negative impact of rising rates. Bond ladders and barbells can be good strategies 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, as continued uncertainty regarding the debt ceiling in Washington implies that it may not be over yet. While some bargain-hunting may happen, traders should be patient and scale-in to any new equity exposure.

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Schwab Center for Financial Research