First, let’s define “worse.” I would call a long-lasting bear market, defined as a decline of 20 percent or more (e.g., in 2000 or 2008), a pretty good definition of what I am worried about. What would it take to get there?
In both of those cases, the break through the trend line was associated with a recession. In fact, this is the case for almost all bear markets. Although 1987 and 1962 are the exceptions here, a recession is the major risk factor we need to watch for that would turn a trend line breakthrough into something worse. If a recession were imminent or even a serious risk, that would significantly raise the chances that this break could get worse.
Fortunately, while the economy may be slowing, it is still growing and at a reasonably healthy pace. Hiring and confidence are strong, and spending continues to grow. Because of the supportive fundamentals, chances of a recession remain small. As such, the likelihood is that this decline will be another false alarm.
Will Confidence Continue?
That is not to say there is no risk at all. While the fundamentals are outside the worry zone for a recession, the real question here is confidence. Up until recently, there was a high degree of confidence that the economy was growing, that companies were making more money, and that the market was solid. That led to steady appreciation and ensured that the dips were small and short lived. The question going forward is whether that confidence will continue. Even in the absence of a recession, a break in confidence could lead to a worse decline in the market.
Fortunately, confidence remains high. In fact, consumer confidence is at an 18-year high, and business confidence is at a multiyear high. These high levels are well supported. As the economy continues to grow, people continue to get hired and spend. As a result, companies are selling more and making more money. None of this was changed by what happened yesterday. Over time, markets typically respond to fundamentals, not temporary changes in confidence.
Could We See A Bigger Pullback?
Certainly, we could see a bigger pullback, just as we did earlier this year and in early 2016. Is this bad day the start of another big crash? So far, the signs don’t support that conclusion.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.