Tuesday (September 13th) turned out to be a very bad day for global stocks, as a hotter than expected US inflation report spooked market participants. The CPI report pushed back on some of the peak inflation narratives and all but confirmed that the Federal Reserve (Fed) will hike rates at least 75 basis points at their September Federal Open Market Committee (FOMC) meeting next week (September 20-21).

“To say the market reacted badly to the inflation report would be an understatement” explained LPL Financial Portfolio Strategist George Smith “The S&P 500 and Nasdaq indices posted their worst days since 2020 but based on history such steep daily declines have proven to be buying opportunities for patient investors willing to wait out volatility”

The S&P 500 index slid 4.3%, the worst single day return since June 2020, and at the close was down 17.5% year-to-date. The more growth oriented Nasdaq 100 saw a daily drop of 5.5%, its worst day since March 2020, leaving it staring down a -27% return year-to-date . As shown in the LPL Research chart of the day, big daily declines over 4% occur, on average, almost twice a year but cluster around recessionary periods.

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Investors looking for some good news can take solace from the fact that following big daily drops, like those that occurred this week, medium-term returns tend to be well above average. The lower proportion of positive returns after such drops does lead to extra caution when interpreting this data.

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A warning sign that the market was getting ahead of itself, among some other speculative signs, was that on Monday both stocks, as measured by the S&P 500 index, and the Volatility Index (VIX) were significantly up, by 1.1% and almost 5% respectively. This is an unusual occurrence as normally the VIX, or the fear gauge as it is sometimes known, and stocks have an inverse relationship. When this inverse relationship breaks down and both move significantly in the same direction it can be a sign that the recent trend is about to turn. Both the VIX and stocks moving down can be an indicator of a trough, while both moving up can be an indicator of a, at least a short term, peak.

Analyzing returns back to 2000, both stocks and the VIX simultaneously rising significantly has only occurred 12 times. Half of these occurrences happened at, or close to, short team peaks and as such tends to be a headwind for ultra-short term returns. Only twice has the following day been even marginally positive, and a week out the historic average and median returns are firmly in the red. Looking at 12 month forward returns doesn’t make pretty reading either, unless the returns are segregated into two groups: the average for recessionary periods is -12% (all negative) versus +22% (all positive) in non-recessionary periods.

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The LPL Research Strategic and Tactical Asset Allocation Committee (STAAC) continues to believe stocks are overly discounting the risk of recession in the near term and that economic and earnings growth in the second half of 2022 can still push stocks higher, consistent with historical strong rebounds from shallow bear markets and midterm election year lows. Investors who are willing, and able, to ride out some volatility may be rewarded with above average returns. Stubbornly high inflation, a potentially overly aggressive Federal Reserve, possible broader military conflict in Europe, and U.S-China tensions still present significant risks, despite not being our base case.