Year to date, the broad-based S&P 500 (SNPINDEX:^GSPC) has advanced 13%, and the technology-heavy Nasdaq Composite (NASDAQINDEX:^IXIC) has added 14%. But the next stock market downturn is only a matter of time.
In the near term, elevated oil prices tied to the Iran conflict, potential interest rate hikes, soaring bond yields, and midterm elections are sources of uncertainty that could drag stocks lower (or even cause a market crash). But history says investors will profit from the next correction if they make one simple move.
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Here are the important details.
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Why the stock market is vulnerable to a downturn
The U.S. stock market is vulnerable to a drawdown (perhaps even a crash) for several reasons. First, President Trump’s tariffs and high energy prices tied to the Iran war have caused inflation to accelerate. At the same time, the Federal Reserve has become increasingly hawkish. Three FOMC members voted for rate hikes at the July meeting, up from zero at the June meeting.
So what? If the Fed raises interest rates, it would mark the first rate hike in a new tightening cycle, and the major stock market indexes have frequently suffered corrections under those conditions. In the last 30 years, following the first hike in a cycle, the S&P 500 and Nasdaq Composite declined by an average of 11% and 14%, respectively, at some point during the next year.
Second, a combination of factors — expectations for higher interest rates, an abundance of corporate bonds issued by artificial intelligence companies, and concerns about national debt — have led investors to sell Treasury bonds, driving yields higher. The 30-year Treasury bond has paid more than 5% for 44 straight trading sessions, the longest stint since 2007.
So what? Treasury bonds look increasingly attractive relative to equities as payouts increase, and the longer yields remain elevated, the more likely investors are to move money from stocks to bonds. The last time 30-year Treasury bonds yielded over 5% for 44 straight trading sessions, the S&P 500 and Nasdaq Composite fell 17% and 14%, respectively, over the next year.
Third, the president’s party tends to lose congressional seats during midterm elections, which creates policy uncertainty that weighs on the stock market. Since 1950, the S&P 500 has declined by an average of 18% at some point during midterm election years, and those loses typically materialized in the third quarter, according to Carson Investment Research.
