Making sense of the recent market volatility

August began with a roller-coaster week of stock trading, with the S&P 500 Index at one pointing declining by 10% from its all-time high set in July. While such stock corrections are a normal part of market cycles, the investor concerns that fueled the recent drawdown continue to linger.

Below, we break down the recent unease around the markets and U.S. economy, as well as provide our insights on where stocks may be headed next.

Are investor fears about the economy legitimate?

In the first six months of 2024, stocks took comfort in the fact that data showed normalizing economic growth, moderating inflation and stable employment trends.

However, under the surface, investors have more recently grown anxious that the Federal Reserve has left its policy rate too high for too long, which could start denting economic growth more forcefully in the coming months. A steady rise in weekly initial jobless claims this year, a below consensus nonfarm payrolls report in July and mixed consumer readings in recent months have put the spotlight back on restrictive Fed rate policy, weighing on stock prices over recent weeks. Specifically, the 2024 July jobs report from the Labor Department showed softer job growth and an uptick in the unemployment rate to 4.3%, the highest level since October 2021. This has caused investors to grow more concerned that the Fed is behind the curve on rate cuts, reigniting recession fears.

In our view, the Fed will likely begin trimming its policy rate of 5.50% starting in September, which should start to alleviate pressure on consumer and business lending trends, as well as reduce investor anxiety that the Fed is somehow behind the curve.

Bottom line: From our standpoint, the economy remains on a solid foundation. Normalizing conditions in the labor market should not be viewed as a sign that a recession is right around the corner. The U.S. economy grew by +1.4% in the first quarter and by +2.8% in the second quarter. We project the U.S. economy to grow by +2.5% for all of 2024, which, if achieved, would remain above the economy’s longer-term growth rate of around +2.0%. With easing inflation pressures likely to continue through year-end, the Federal Reserve now has room to reduce its policy rate, which could help economic growth remain positive through the rest of this year.

Is there weakness brewing in the stock market?

From an earnings perspective, Q2 growth among S&P 500 companies was very positive, with companies in aggregate growing earnings per share by over +10% year-over-year and overall conditions/spending in the U.S. remaining firm. However, a few negative earnings reports and mixed outlooks from Big Tech on consumer and business trends were points of concerns for investors. This mixed showing, along with the aforementioned anxiety around the economy, contributed to the decline in the major U.S. stock averages over recent weeks.

In our view, the overall stock market may continue to see volatility through the rest of summer, possibly driven by some repricing in expectations around tech and tech-related stocks, which notched very strong gains in the first half. Note: Both information technology and communication services were higher by over +25% over the first six months of the year. These two sectors account for nearly 40% of the S&P 500 Index. It would be unreasonable for investors to assume these two sectors and the companies that power these sectors would rise in perpetuity without facing some volatility this year.

That said, second quarter earnings results for these sectors have come in solid despite mixed outlooks and artificial intelligence spending continuing to accelerate. Without a clear payoff window for AI, some investors appear comfortable booking some profits following the big stock price gains in the first half. Nevertheless, several companies across these sectors continue to be the secular drivers of the U.S. economy. Notably, if the selling pressure across Big Tech continues, we suspect long-term investors, at some point, will likely take advantage of better pricing/valuations.

Still, market fundamentals remain firm and there are reasonable valuations to be found in the current environment. Outside of tech and communication services, valuations for most of the market are not as expensive as the S&P 500 implies, including financials, industrials and U.S. small-cap stocks. In our view, several cyclical and defensive areas of the market trade at very reasonable valuations based on earnings expectations. Investors began to recognize this dynamic starting in July. Absent a notable deterioration in economic conditions, further weakness in these areas may pose an opportunity for investors.

Is the volatility an aberration or a symptom of something bigger?

It is important to remember that spikes in market volatility, stock corrections and periods of consolidation are all normal functions of a healthy and dynamic financial market. Historically, drawdowns of 5% or more from a market top in the S&P 500 Index happen a few times a year, while a correction of 10% or more typically occurs once a year.

Interestingly, Goldman Sachs recently noted that investors typically do well when buying stocks during periods of stress. Following a 5% drawdown in the S&P 500, the median return for the Index is +6.0% over the next three months, with positive returns seen 84% of the time.

And while the NASDAQ fell more than 10% from its recent top in early August, long-term investors usually do well if they sit tight and ride out the pressure. According to Bespoke Investment Group, the typical NASDAQ correction lasts 42 days and sees an average drawdown of 17%. However, if you have a holding period of one year or longer and bought the tech-heavy index at the start of the correction (which admittedly is not great timing), historically, annualized returns one year to ten years forward look very similar to the historical average. While historical trends are never a guarantee of future returns, making rash decisions around your portfolio during periods of market stress is seldom a wise choice.

In addition, August and September can be volatile months for stock investors. Volatility tends to rise in August, and for some unknown reason it can be an event-driven month. If we look to history, Iraq invading Kuwait, the Asian contagion crisis, a Russian default/Long-Term Capital Management failure, a European debt crisis, a U.S. debt downgrade, China unexpectedly devaluing the yuan and the yen carry trade unwinding all started in August. Each of these months (sans this month’s yen unwind) saw volatility spike and stocks fall in August. And every time, the stock market recovered and eventually moved on to new highs. A little perspective and a well-thought-out investment strategy usually go a long way in helping investors navigate the expected and sometimes unexpected turbulence that routinely develops across financial markets.

Bottom line

Emotions can get in the way of a successful long-term investment strategy. When stocks start to slide, it’s natural to want to mitigate risk and sell. However, history shows that the difficult practice of staying the course — or buying stocks while others are selling — can pay off in the long run.

An Ameriprise financial advisor can recommend systematic strategies, such as dollar-cost averaging, to help you accumulate wealth over time, while also identifying potentially attractive buying opportunities if you have excess cash sitting on the sidelines.