Is a market correction coming?

Bull market momentum extending back to October 2022 was interrupted in early August. Investor sentiment shifted, reflecting concerns about the strength of the U.S. economy. These concerns stemmed from a jobs market report, issued on August 2, showing relatively modest job gains in July along with an uptick in the nation’s unemployment rate.¹ It raised concerns that the economy may face increasing headwinds, and that the Federal Reserve (Fed) may have been too slow to initiate long-promised interest rate cuts, which are expected to bolster the economy. Stock markets experienced precipitous declines on consecutive trading days (August 2 and August 5).

Based on the definition of a market correction representing a 10% or greater decline in value, the technology-heavy NASDAQ Composite Index experienced a correction. At the end of August 5th’s trading day, it was down 13% from its July 10, 2024, high. The S&P 500 neared correction territory, dropping 8.5% from its July 16 peak.² Investors may now be asking whether the recent setback for the market is a temporary blip in what has been a year of solid equity performance, or if it is a signal of what could represent serious economic challenges that might have more significant market ramifications.

Markets may prove resilient

“Despite the negative market action, we don’t believe that there’s a reason for equity investors to exercise significant caution,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. “We still think it’s a great time to be invested and for those with money in cash, it represents an opportunity to put capital to work in longer-term assets.”

The market’s sudden decline is not out of the ordinary. “It’s important for investors to remember that drawdowns of 5% to 10% or more in a given year are not unusual, even in the context of a generally positive market environment,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management.

“The early August correction appears to be more of a reflection of challenges in the financial economy rather than in the real economy.” Haworth says some traders who used borrowed funds to purchase equity positions had to quickly sell off some of their stock holdings to meet obligations of their borrowing arrangements. In addition, a surprise interest rate hike by Japan’s central bank resulted in the Japanese yen appreciating in value, resulting in suddenly higher borrowing costs that put pressure on leveraged investors. “That represents some of the financial stress we’ve seen in the system,” says Haworth. “Today’s circumstances do not represent an economic crisis, or a repeat of the market crash environment of 1987.”

Markets are closely attuned to the Fed's actions. Between March 2022 and July 2023, the Fed bumped the federal funds target rate it controls from near 0% to a peak of 5.50%. After the policymaking Federal Open Market Committee (FOMC) met in July, Fed Chair Jerome Powell indicated the likelihood that the Fed would cut rates at its September meeting.³ Two days later, the jobs report triggered market questions surrounding whether or not the Fed should lower interest rates more quickly.

“This gets back to the state of the real economy. It’s not as strong as it was, but it doesn’t show signs yet of breaking down,” says Haworth. “Corporate earnings remain strong, the unemployment rate is up, but mainly because more people are entering the labor force. Most fundamental signs remain positive.”

A broad-based decline

Investors have been waiting for the market’s gains, concentrated to this point on large-cap stocks, to extend to mid-cap and small-cap issues. In July, small stocks outperformed, with the Russell 2000 Small-Cap Index gaining 10.16%, compared to 1.22% for the large-cap S&P 500.⁴ “Prospects of Fed rate cuts resulted in a short-term pivot into smaller stocks,” says Haworth. But the rotation to smaller-cap stocks was sidetracked in early August.

The August turnaround took a toll on stocks regardless of market capitalization. In just the first three trading days of the month, both the large-cap S&P 500 and the Russell Mid-Cap Index were down close to 6%. The small-cap Russell 2000 lost 9.5%.4 In July, markets were enthusiastic about the potential that pending Fed rate cuts could ease the burden of borrowing costs, which fall disproportionately on smaller companies than on large-cap stocks. “But now markets became concerned that the Fed’s delays might have negative economic ramifications, which could affect forward earnings for small cap stocks,” says Haworth. August’s significant equity market setback tempered year-to-date returns among the three primary market capitalization performance measures.

A modest rotation begins

Throughout 2023 and up to June 30, 2024, technology stocks drove S&P 500 performance. Since the end of June, the technology and communication services sectors lagged the rest of the S&P 500. While most of the 11 S&P 500 sectors experienced negative performance since June 30, utilities, consumer staples and real estate stocks gained ground during this period.⁵

Source: S&P Dow Jones Indices, LLC. As of August 5, 2024.

Notably, based on year-to-date through August 5, utilities stocks overtook information technology, and only slightly trailed communications services stocks.

Key stock market drivers for the remainder of the year

What are the keys to a sustained bull market? The primary considerations that deserve attention include:

• Inflation and labor market trends and their impact on future Fed policy moves. “The attention of the Fed, which was previously centered on tempering inflation, is now focused as well on the labor market,” says Haworth. The Fed is expected to initiate rate cuts at its next meeting on September 17-18.
• Consumer and business spending. “Consumers’ willingness to maintain reasonable spending growth has been an economic linchpin,” says Haworth. The labor market’s strength, including solid wage growth, contributed to that factor. The U.S. economy grew at an annualized rate of 2.8% in the second quarter, double its first quarter growth rate.6 “The economy may be growing at a slower pace than before, but not at a pace yet where we consider it to be a recession risk,” says Haworth.
• Corporate earnings and stock valuations. Second quarter earnings, as reported to date, are growing at an 11% pace compared to 2nd quarter 2023 earnings. “Despite their challenges since late June, technology stocks are still the biggest driver of corporate earnings,” says Haworth. The path of earnings over the course of 2024 may play a big part in determining the risk of a further market correction.

External risks must also be considered. Current issues include the impact of global tensions highlighted by the Israel-Hamas conflict and the Russia-Ukraine war. The heated lead-up to what appears likely to be a contentious presidential election may ultimately draw more investor attention.

Equities still offer opportunity

While the forward view for diversified portfolios remains constructive, recent market events may offer an opportunity to reassess your financial assets relative to goals. You want to ensure that your portfolio is aligned with your long-term objectives.

Haworth says investors may wish to consider diversifying with an equal-weighted S&P 500 exchange-traded fund. Such a fund puts less emphasis on the largest stocks in the Index compared to a traditional S&P 500 fund, seeking to capitalize on opportunities in what have been underperforming stocks in the index.

Haworth adds that “for those with money on the sidelines waiting for a bell to ring to get back into the market, the bell has rung.” He suggests investors “consider putting a portion of your portfolio to work in equities in a systematic way, such as dollar-cost averaging available cash over a series of months.”

Freedman encourages investors to view markets with a long-term lens. “Timing the markets and trying to be precise on when to be in and when to be out is challenging,” says Freedman. “Markets will do things at the exact opposite time you expect them to.”

This is an important time to check in with a wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio is structured in a manner consistent with your time horizon, risk appetite and long-term financial goals.

The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. Diversification and asset allocation do not guarantee returns or protect against losses. The Russell MidCap Index provides investors with a benchmark for mid-sized companies. The index, which is distinct from the large-cap S&P 500, is designed to measure the performance of mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment. The Russell 2000 Index refers to a stock market index that measures the performance of the 2,000 smaller companies included in the Russell 3000 Index.