The concept of prospect theory in behavioral economics, which suggests that the pain of a loss is greater than the expectation of a gain, was evident as the S & P 500 dropped sharply in the final hours of trading on Thursday. President Joe Biden’s call for an immediate ceasefire in Gaza and reports of Israel preparing for potential retaliation from Iran impacted bond prices, yields, and oil prices. Neel Kashkari of the Federal Reserve Bank of Minneapolis questioned the need for rate cuts if inflation remains stable, with the S & P 500 only 2% below record highs despite the recent declines.
The S & P 500 has been on an upward trajectory for five consecutive months, driven by consistent earnings expectations for the first quarter and the year ahead. Although estimates for first-quarter earnings have decreased to a projected gain of 5.1% from the initial estimate of 7.2%, analysts have made smaller cuts than usual. However, the question arises as to what could lead to a more substantial decline in stocks, such as a drop of 10% or more, which would require a significant deviation in earnings estimates.
Factors that could trigger a more substantial stock market decline include a notable economic downturn, a sustained increase in interest rates, or an unexpected external shock. While job growth remains strong and interest rates are stable for now, reports of potential retaliation between Israel and Iran brought uncertainty to the market. The possibility of “sticky inflation” affecting rate expectations may moderate market momentum, but a 10% drop would likely require a significant economic deterioration.
Market declines of 10% or more are relatively common occurrences, happening in 50% of years from 2002 to 2021 with an average pullback of 15%. Despite these fluctuations, stocks generally saw positive returns in most years, highlighting the importance of preparing for market volatility. Recency bias, fueled by recent market trends, may lead investors to underestimate the likelihood of significant market declines, neglecting the cyclical nature of market movements. Being mindful of potential fluctuations and preparing for different scenarios is essential for navigating the unpredictable nature of the stock market.
