Sometimes it's pretty obvious why the stock market is falling. And when that's the case, it's actually a good scenario for investors. If you understand why stocks are dropping, you're likely to have a better idea about how to respond. For instance, in March 2020, we knew what was spooking investors -- the threat of COVID-19. Crashes are often accompanied by a surge in negative emotions.
Nonetheless, if you keep your wits about you, sharp market downturns can be investing opportunities. After all, we all knew what companies might be best positioned to thrive during a serious outbreak of an infectious disease -- vaccine companies. At the start of 2020, I owned shares of Novavax (NVAX 4.63%). The whole rest of my portfolio was bleeding red ink -- except for that biotech company, which was spiking higher day after day. Novavax stock ran up 3,000% that year.
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The market drop in January 2022 was a different beast. My portfolio lost 20% in 31 days. It would have been a lot worse, too, but the market bounced a bit during the last three days of the month. And this time, it's not nearly as obvious why the market tanked. Was it lingering concerns over the rapidly spreading omicron variant of COVID-19? Or maybe fear of a Russian invasion of Ukraine? Or perhaps it was unusually high inflation and worries about what rising interest rates will do to businesses' top and bottom lines.
Below, I'll discuss several possible explanations for why the market fell so far in January.
1. Profit-taking
You might have forgotten this, but the stock market just had two really high-returning years in a row. In 2020, the S&P 500 gained 16%, even though it was the first year of the pandemic. A lot of internet stocks put up great numbers. Many stocks in many sectors were hammered, but overall, the market did just fine.
From the chart above, you can see that people who bought stocks during the dark days of March did really, really well. Even the people who bought on Jan. 1 -- before the world recognized the coming crisis -- had a solid return in their portfolio.
Of course, 2021 was even better for the index. That was the year that people first started getting vaccinated against COVID-19. After research and development processes that were super-fast compared to the usual pace in the pharmaceutical industry, Moderna (MRNA 0.62%) and Pfizer (PFE 1.16%) received Emergency Use Authorizations for their highly effective mRNA vaccines. So there was a lot more optimism buoying society in 2021. And the stock market plowed ahead, gaining another 27% for the year.
As a result, the stock market was up a remarkable 47% in that two-year period, even though many parts of the economy had performed horribly because of COVID.
But by late 2021, many people started feeling more negative. The pandemic failed to disappear. Everybody is sick of social distancing, the need for masks, and the resurgent COVID-19 threat caused by the omicron variant.
So in January, the market got hit with a double-whammy. A lot of people were feeling pessimistic about not getting back to "normal." Simultaneously, a lot of investors were sitting on massive stock gains from the previous two years. And then, a lot of those folks anticipating downbeat times ahead decided that this would be a good time to take some profits.
2. Tax planning
Traders often like to wait until January to sell stocks, and there's a reason for that. When you sell shares at a profit, the next year, come April 15, you have to pay taxes on your capital gains. By selling in January, you extend the period you have before that tax bill comes due -- in this case, until April 15, 2023. Thus, tax laws encourage a concentration of profit-taking sales in January.
And so, early in January, a surge of selling began, and the market started to fall. And it continued to fall. The slide steepened, and until the final few days of the month, it was ugly.
At one point, people were talking about the possibility that last month would be the worst January market performance they had ever seen. But then, with sharp gains over its final three days, the S&P 500 ended up down 5% for the month.
I was a bit surprised. Down 5% in a month is hardly the end of the world. In January, there were a couple of ugly sessions when my portfolio dropped 5% in a day! This shows how dangerous it can be to have a short-term time horizon in investing. If you're patient and stay focused on the longer-term picture, the short-term ups and downs are more tolerable. It's only when you're in the middle of a huge drop that you feel like you want to get off the roller coaster.
3. What about omicron? Or the possibility that Russia might invade Ukraine? Or rising interest rates?
When it's not clear why the market is falling, all you can do is speculate. Some pundits thought that fears about the possible economic impacts of the omicron surge were causing traders to bid stocks down. Others pointed to the possibility of war in Ukraine. And while the stock market hates rising interest rates, the Fed had already warned us that it will have to raise interest rates from their current rock-bottom levels in order to try to get inflation back in check.
Of course, we can't be certain why so many people decided to sell their stocks in January. But I'm pretty sure it wasn't omicron because Novavax and Moderna both got hammered too. When the world's worried about COVID-19, vaccine stocks go up, not down.
There is no war in Ukraine yet, although some people might speculate about worst-case scenarios. As for interest rates going up, the benchmark fed funds interest rate is effectively zero right now. The Fed will have to raise interest rates a heck of a lot before the bond market will start to look good.
In fact, because of inflationary pressures, sitting in cash is kind of a horrible move. If you put your cash under a mattress a year ago, you've lost 7% of your purchasing power.
So, my conclusion is that this decline was caused by profit-taking. And then there was some irrational fear about various things. And fear, like interest, can compound. (Of course, interest compounds over long time frames. Fear compounds quickly, and it becomes a panic.) And then -- and this always happens -- a few brave souls notice how cheap the market is, and the bulls rush in and start buying again.
