The upside to challenging market environments like these is that they remind us that long-term investment success requires patience. It's important to never focus on or overreact to short-term market performance, especially over a single day. However, it is always valuable to understand what is driving investor concerns. In short, investors are worried about inflation that has remained hotter for longer and its impact on Fed policy. In these uncertain times, it's more important than ever for investors to stay patient, invested and diversified.
The stock market recently experienced its worst day in two-and-a-half years due to worse-than-expected inflation data. The S&P 500 fell 4.3% and the Nasdaq 5.2%, bringing their year-to-date declines to 17.5% and 25.6%, respectively. It's important to keep in mind that despite this year's challenges, investors have still done very well over the past few years due to the swift market and economic recovery since 2020. Still, there's no denying that these market swings add to the general air of uncertainty driven by rising interest rates due to inflation and the Fed, fluctuating energy prices due to the war in Ukraine, the stronger U.S. dollar, the slowing economy, and more.
The stock market continues to fluctuate due to macro-economic factors
Specifically, the latest Consumer Price Index report for August showed that overall inflation increased by 8.3% over the previous year and accelerated over the month. This occurred despite energy prices falling by 5% month-over-month, including gasoline prices which fell by 10%. This is because "core" inflation, i.e. inflation without food and energy, rose at a faster-than-expected pace. For many investors and economists, this is worrisome because it means that inflation has broadened across many categories and will be less likely to reverse quickly on its own. For example, services costs, which include shelter, medical care, transportation services and make up 56% of consumer spending, increased by 0.6% month-over-month.
This is why many investors and economists now expect the Fed to raise rates more quickly and to keep rates higher in order to prevent inflation from worsening further. The market anticipates the Fed will raise the federal funds rate to over 4% by year end, up from a prior expectation of 3.75%. This includes a rate hike of 75 basis points at their September meeting - and possibly even a full percent. This has pushed all interest rates higher with the 10-year Treasury yield now climbing above 3.4%, returning to its June level.
The Fed is expected to hike faster and keep rates higher for longer
How should investors interpret the latest data and market moves? Markets had already digested a faster path of Fed rate hikes, a fact that drove the rebound during the middle of the summer. Fed Chair Powell's speech at Jackson Hole that the Fed will continue to take inflation seriously by keeping rates higher for longer ended this rally, but in hindsight it helped to properly set market expectations for this latest data. Investors who had written 3.75% into their financial models need to adjust these numbers higher. Thus, this is a situation in which markets need time to adjust to new expectations before it can move forward, as is always the case.
For these reasons, there is perhaps nothing more important for long-term investors than to simply stay invested. History shows that regardless of the causes of market uncertainty, trying to time the market not only fails but often backfires. The chart below shows that holding on after single-day market drops was far superior to getting out of the market, even for brief periods. The fact that it is difficult to overcome this natural hesitation and fear is why those who are able to do so are often rewarded.
Staying invested is the key to long-term investing
In addition, the challenge with selling investments is that cash is directly impacted by rising inflation. After all, the very definition of inflation is that it erodes the purchasing power of cash, whether this cash is held in savings accounts or hard currency. Unlike stocks and bonds, cash does not have a way to regain its value once it falls behind. In contrast, investing in companies that have pricing power can help to combat inflation in one's portfolio. So, while investing naturally comes with risks, investors who are able to stay patient are often rewarded as markets recover and grow in the long run.
The bottom line? Investors should stay patient and invested, and not overreact to short-term developments. History shows that this is still the best way to achieve long-term financial goals.