Finance professor comments on stock market drop

Published: October 16, 2018
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Albert Wang, associate professor of finance in the Harbert College of Business, provides comments on the recent stock market drop. To arrange an interview with Wang, please contact Preston Sparks, Auburn University director of communications, at 334-844-9999 or pjs0027@auburn.edu.

The selloff was led by tech shares, which had done very well so far this year. The drop in the prices of FANG shares (Facebook, Amazon, Netflix, Google) was particularly sharp on Wednesday. The drop in stock prices was not contained to technology stocks. Even safety stocks such as utilities took a hit, albeit a smaller one. Many interpreted last week’s selloff as a correction, feeling that U.S. stocks could not move in an opposite direction from global stocks forever. Since 2018, the S&P 500 had risen 8.52 percent year to date before last week’s selloff, while global stock indices have fallen. Global stocks have been largely weighed down by a strengthening dollar and heightened trade tensions. Chris Weston, head of research at Pepperstone Group Limited in Melbourne notes “Statistically, it feels as though convergence is due.”

The cause of this correction is debatable. President Trump chooses to blame the U.S. Federal Reserve for tightening monetary policy. However, this selloff also follows news from 10/8/2018 that the IMF cut its forecast for global growth, including a fall of 0.9 percent of output for U.S. The ongoing trade war between China and U.S., with the ripple effect to other markets, is the main driving force behind such downward forecast.

While investors may be tempted to hide in safety and value stocks, those will likely perform poorly if a bear market persists. Alternatively, investors should consider investments in bonds to hedge against recession risk, as well as gold to protect against inflation. A trade war, on the tail end of a period of easy money monetary policy, could lead to runaway inflation. Charles Himmelberg, chief markets economist at Goldman Sachs, states “The behavior of stock, bond and commodity markets last week showed investors’ main concern that higher oil prices would feed into inflation and interest rates.” Despite these fears, the Wall Street Journal notes “Widespread fears of inflation are at odds with actual inflation behavior. In September, consumer prices rose by less than economists expected for the fourth straight month. Excluding food and energy, they’re up at a 1.8 percent annual rate in the last three months, the Labor Department reported Thursday.”

On top of inflation fears, the risk of a recession is also increasing, with the majority of economists predicting a recession by the end of 2020. Despite the prediction by economists, the yield curve has not yet inverted. As of 10/15/2018, the 10-year treasury yields 31 basis points more than the 2-year treasury. Put options provide an additional way to hedge against this recession risk. Put options with a January 2021 strike date recently became available for the S&P 500 and Dow Jones Industrial Average ETFs (SPY, DIA.) Some investors may wish to buy a protective put to hedge against a possible recession, especially because economists predict a recession before the January 2021 strike date.

While the selloff has been put on hold and we observe some rebound in the stock market, the market is still very volatile. Institutional investors have accumulated heavy long positions on VIX futures, an index that indicates the fear of a big meltdown of S&P 500. With the third quarter reports due in a few weeks, investors should pay close attention to any risks that may affect maintaining the profit, such as less cash flows from financing, reduced stock repurchase and etc.