Did the markets spooke you last week?

If you are a non-professional trader who finds it challenging to manage emotions, you may have experienced anxiety last week as the markets faced a significant decline.

Last week marked the end of six weeks of gains in the stock market.

Such decline was primarily driven by increasing bond yields that captured the attention of investors. It has been just over a month since the Federal Reserve initiated a new easing cycle, implementing an unexpected half-percentage point cut to its policy rate. Yet, both 2-year and 10-year Treasury yields have risen, complicating the prevailing narrative.

Was it spooky? Yes, it was.

But to effectively address fear, it is essential to comprehend the underlying factors at play.

Here are several points that elucidate the recent market developments:

1. October’s Historical Reputation

October is often associated with stock market declines. Notable crashes, including the 1907 Bank Panic, the 1929 stock market crash that precipitated the Great Depression, Black Monday in 1987, and the 2008 global financial crisis, all occurred in this month. Investopedia describes the “October Effect” as the psychological belief that financial downturns and stock market crashes are more likely to happen in October. If you hold superstitious beliefs, you may wish to reconsider your trading activities during this month.

2. Strong Economic Data

Recent reports indicate that economic performance has exceeded expectations. Job gains in September were the highest recorded in six months, and a decrease in unemployment has alleviated concerns regarding the labor market's stability. Furthermore, significant growth in retail sales has prompted the Federal Reserve to raise its real-time GDP estimate for the third quarter to 3.4%. Should this estimate prove accurate, it would signify the second consecutive quarter of above-average growth, alleviating fears of a recession.

3. Slower Interest Rate Cuts

Despite robust economic indicators, markets have had to recalibrate in response to a slight inflation surprise, resulting in expectations that interest rate reductions will occur at a more gradual pace than previously forecasted during the September FED meeting. As a result, bond markets have made minor adjustments to anticipated future interest rate trajectories.

4. Valuation Concerns for Major Technology Firms

The earnings reports from major big-tech companies have been varied. It appears we may have reached a juncture where the excitement surrounding artificial intelligence and its possibilities is no longer adequate. Although these firms possess strong long-term growth potential, they are failing to achieve the growth levels that the market has already factored in.

5. Anticipated Increase in Productivity

One factor contributing to the U.S. economy's ability to surpass expectations of a slowdown is the significant rise in productivity, a trend not seen in other leading economies. This indicates the possibility of elevating the long-term growth rate of the United States. A more efficient economy could support sustained higher growth without triggering inflation, thereby allowing for elevated steady-state interest rates compared to the previous economic cycle.

6. Worries Regarding U.S. Debt and the Upcoming Election

The presidential election is approaching, raising concerns about fiscal policy. According to campaign proposals, debt levels are likely to escalate under either candidate. Expansionary fiscal measures, whether through tax reductions or increased spending, may necessitate the FED to uphold higher policy rates. Additionally, the increased issuance of bonds required to finance the rising debt could exert upward pressure on long-term Treasury yields. As the probability of a Trump victory rises in betting markets, investors are contemplating the potential consequences of heightened trade tariffs. While economic theory posits that tariffs would lead to inflation, the actual effects on consumers are multifaceted. Some of the additional costs may be absorbed by retailers, and a potential depreciation of foreign currencies against the U.S. dollar could result in lower prices.

7. Geopolitacl tensions on the rise

Although the "world revolves around the US dollar", it is essential to consider the current geopolitical context: the situation in Ukraine has intensified; the hostilities involving Israel, Hamas, and Hezbollah persist; China remains steadfast in its ambitions regarding Taiwan; and North Korea has adopted a more confrontational nuclear stance in the region.

Historical events such as the stock market crash of 1987, the financial crisis of 2008, the global pandemic in 2020, and Russia's invasion of Ukraine in 2022 have demonstrated that unforeseen occurrences often lead to substantial volatility in the stock market. The VIX index, which gauges the implied volatility of put and call options on S&P 500 stocks, serves as an indicator of the most diversified U.S. stock market index. Typically, investors engage in selling options during periods of stability and market optimism, but they tend to shift towards purchasing options when the probability of a market downturn rises, resulting in significant market declines.