One of the pillars of behavioral economics is so-called prospect theory, which holds that the pain of losses is far greater than the expectation of gains. This insight from 2002 Nobel Prize winner Daniel Kahneman was on full display Thursday, as the S&P 500 fell 100 points in the final 2 hours and 30 minutes of trading. U.S. President Joe Biden called for an immediate ceasefire in Gaza and more protection for aid workers in a phone call with Israeli Prime Minister Benjamin Netanyahu on Thursday. News reports say Israel is preparing for possible Iranian retaliation. Bond prices rose, yields fell, and oil prices rose. Later in the day, Minneapolis Fed President Neel Kashkari said he wanted to know whether the Fed should cut interest rates this year if inflation continues to trade sideways. Despite Thursday’s losses, the S&P 500 is down just 2% from last week’s record high. The surprise wasn’t the S&P 500’s decline on Thursday. Precisely because it has been so stable, the S&P 500 has risen significantly for five consecutive months, largely because earnings expectations for the first quarter and this year have been very stable. .SPX 6M mountain S&P 500, 6 months First-quarter earnings estimates for the S&P 500 have slipped to an expected gain of 5.1%, down from the 7.2% gain expected on January 1, according to LSEG. The decline is not surprising given that expectations typically start higher at the beginning of a quarter and decline towards the end. Reported earnings typically beat analysts’ lower expectations, often by 3% to 6%. FactSet senior earnings analyst John Butters confirmed that analysts’ first-quarter cuts were smaller than average. What could cause a stock to fall more severely? Since earnings are what ultimately drives stocks, the question isn’t “What would cause a small decline of 2% to 5%?” Everyone should expect this given the results achieved. Instead, we should ask: “What would cause a larger decline of 10% or more?” For this to happen, market participants need to believe that profit expectations will deviate significantly. What would cause a significant drop in revenue? This is usually a combination of factors: 1) expectations of a significant decline in the economy, especially in terms of employment; 2) a significant and sustainable spike in interest rates; 3) some kind of unexpected exogenous shock (e.g. the 1970s the Arab oil embargo, COVID-19 or war). The first two haven’t happened, at least not yet. Job growth remains strong – we’ll have to wait and see how March’s employment data turns out. Furthermore, interest rates are not continuing to surge just yet. External impact? Reports that Israel was preparing for possible retaliation from Iran appeared to surprise markets on Thursday. What about the current problem, so-called “sticky inflation”? Markets may be a little disappointed that rate cut expectations don’t materialize, but on that basis alone, it seems unlikely that the market will fall by 10%. The economy has not deteriorated significantly either. Market drops of 10% are more common than you think If you think that a market drop of 10% is unlikely or would be a disaster, that’s not the case. It’s common for markets to drop 10% or more. It turns out that investors are very worried about economic weakness or external shocks and how they might affect earnings. A 2022 study from Charles Schwab examined stock market declines from 2002 to 2021. The analysis found that in 10 of 20 years (that is, 50% of the time) the stock market fell by at least 10%, with an average correction of 15%. “Despite these pullbacks, stocks have risen in most years, posting positive returns in all but three years, with gains averaging about 7%,” the report said. So buckle up. Those who believe big declines are uncommon suffer from recency bias: Because the market has been rising almost in a straight line over the past 18 months, they believe this is the natural direction for stocks for the foreseeable future. They would be wrong.
