One of the pillars of behavioral economics is so-called prospect theory, the idea that the pain of loss is much greater than the expectation of gain. This insight, developed by Daniel Kahneman, winner of the 2002 Nobel Memorial Prize in Economic Sciences, was abundantly clear on Thursday, as the S&P 500 fell 100 points in the final two hours and thirty minutes of trading. President Joe Biden spoke Thursday with Israeli Prime Minister Benjamin Netanyahu, calling for an immediate ceasefire in Gaza and more protection for aid workers. News reports also surfaced that Israel was preparing for possible retaliation by Iran. Bond prices rose, yields fell, and oil prices rose. Later in the day, Minneapolis Fed President Neel Kashkari said that if inflation continues to move sideways, he questions whether the Fed should cut interest rates at all this year. Despite Thursday's declines, the S&P 500 is only 2% from its record highs set last week. The surprise is not that the S&P 500 fell on Thursday. It's been so steady, the S&P 500 has been on an upward trajectory for an impressive five straight months, largely because earnings expectations for the first quarter and this year have been so stable. .SPX 6M Mountain S&P 500, 6 Months First-quarter earnings estimates for the S&P 500 index fell to an expected gain of 5.1%, down from the 7.2% increase expected on Jan. 1, according to LSEG. This decline is not surprising given that estimates usually start high at the beginning of the quarter, then decline somewhat at the end of the quarter. Reported earnings typically beat lower analyst estimates, typically by 3% to 6%. John Butters, senior earnings analyst at FactSet, confirmed that analysts made lower-than-average cuts to first-quarter estimates. What might cause a more serious decline in stocks? Since earnings are ultimately what move stocks, the question is not “What would lead to a modest 2% to 5% decline?” Everyone should expect that, given the gains. Instead, we should ask: “What would cause a greater decline of 10% or more?” To do this, market participants would need to believe that earnings estimates were widely divergent. What could lead to a significant decrease in profits? This is usually a combination of factors: 1) the expectation of a significant decline in the economy, especially in jobs, 2) a significant and sustained rise in interest rates, and 3) some type of unexpected external shock (for example: the Arab oil embargo in 1970s, Covid, or war). The first two won't happen, at least not yet. Job growth remains strong – we'll see how March payrolls turn out. Furthermore, there is no sustainable rise in interest rates at the moment. External shock? Reports that Israel is preparing for possible retaliation against Iran appeared to have caught markets by surprise on Thursday. What about the current scary thing, so-called “sticky inflation”? Unfulfilled expectations of interest rate cuts may take some air out of the market, but it seems unlikely that the market will drop 10% because of that alone. Not without a major deterioration in the economy. A 10% market drop is more common than you think. If you think a 10% market drop is unlikely or would be a disaster, it won't be. A market decline of 10% or more is very common. It turns out that investors worry a lot about economic weakness or external shocks and how they might affect earnings. A 2022 study by Charles Schwab looked at stock market declines from 2002 to 2021. The analysis found that a decline of at least 10% occurred in 10 out of 20 years, or 50% of the time, with an average decline of 15%. . “Despite these declines, stocks rose in most years, with positive returns in all but three years and an average gain of about 7%,” the report said. So get ready. People who believe that marked declines are uncommon suffer from recency bias: Because the market has risen almost straight up over the past 18 months, they believe this is the normal trend for stocks for the foreseeable future. They would be wrong.
