And you thought you had a bad week.
The Dow Jones Industrial Average fell 665 points this week, its worst showing since late August, when it plunged 1,000 points. What happened? The Federal Reserve.
A strong jobs report last week, when employers added more workers to their payrolls than expected, led to speculation that the Fed would go ahead with a rate increase next month. A series of speeches by Fed officials on Thursday added to the market’s conviction that the Fed was likely to raise rates. The Dow dropped 250 points on Thursday, followed by another 200 points on Friday.
The drop put the stock market, which had bounced back in October, back in the red for the year. At the close on Friday, the Dow was down 3.2% for the year. The S&P 500 was also down 1.7%.
The problem is that while the U.S. economy is improving, a Fed interest rate hike might put us out of whack with the rest of the world. Foreign central banks are months, if not years, from raising interest rates. That dynamic could lead to a stronger dollar. So, while a rate hike could be right for the U.S. economy, it could still hurt the profits of many of the large companies in the Dow, and the S&P 500, which rely on exports.
And a rising dollar could come at a time when U.S. corporate profits are already hurting. On average, earnings at companies in the S&P 500 fell 3.7% in the third quarter, according to FactSet. Profits were down in the second quarter as well, the first time we have had a consecutive quarterly profit decline since the recession.
What’s more, while many have long expected a rate hike, stock market investors seemed to be caught off guard. Many of the sectors that do well when interest rates rise were still lagging the rest of the market. That may have caused some investors to sell shares in companies that were particularly sensitive to interest rate increases.
The other problem is that stock prices compared to profits, and especially sales growth, are historically high, given the weak economy. James Paulsen, chief investment strategist at Wells Capital Management, said in a note on Friday that, on a price-to-sales ratio, U.S. stocks have not been this expensive since the dot-com bust. “Compared to the rest of the world, U.S. economic performance, U.S. company fundamentals and the U.S. stock market have directionally diverged by more in this recovery than in any during the last 20 years,” wrote Paulsen.
The fact that the U.S. economy is doing better than the rest of the world is good news. But it won’t necessarily save the stock market from some rough times ahead.