One of the core principles of behavioral economics is prospect theory, which suggests that the pain of a loss outweighs the joy of a gain. This concept was evident on Thursday as the S&P 500 experienced a significant drop in the final hours of trading. President Joe Biden intervened in the ongoing conflict in Gaza by urging for an immediate ceasefire and increased protection for aid workers. Reports of Israel bracing for possible retaliation from Iran also influenced market movements, leading to a rise in bond prices, a decline in yields, and a rally in oil prices. Neel Kashkari of the Federal Reserve Bank of Minneapolis speculated about potential rate cuts if inflation remains stagnant. Despite the day’s losses, the S&P 500 is still only 2% away from its record highs, reflecting its remarkable stability in recent months.
The S&P 500 has maintained a steady upward trajectory for five consecutive months due to stable earnings expectations for the first quarter and the year overall. However, estimates for first-quarter earnings growth have slightly decreased to 5.1%, down from an initial projection of 7.2% at the start of the year. Analysts typically revise their estimates downward towards the end of a quarter, but reported earnings tend to surpass these lowered expectations by 3% to 6%. To trigger a more substantial decline in stocks of 10% or more, significant discrepancies in earnings estimates would need to occur. Factors such as a sharp economic downturn, a sustained increase in interest rates, or unexpected external shocks like geopolitical conflicts could potentially lead to such a scenario.
Market participants are concerned about potential triggers for a significant market drop, with the expectation that earnings ultimately drive stock movements. While some uncertainties such as the possibility of rate cuts not materializing could impact market sentiment, a substantial decline would likely require more severe economic disruptions. Reports of Israel preparing for potential retaliation from Iran sparked some unease in the markets, but this alone may not be enough to trigger a 10% market decline without broader economic deterioration. Historical data indicates that market declines of 10% or more are not uncommon, occurring in 50% of years from 2002 to 2021, with an average pullback of 15%.
Investors who perceive significant market declines as unusual may be influenced by recency bias, assuming that recent market trends will continue indefinitely. However, historical precedent shows that market fluctuations are a normal part of the investment landscape, with stocks generally rebounding after pullbacks. Despite periodic market turbulence, stocks have generally delivered positive returns over the long term. As such, investors should be prepared for market volatility and understand that notable declines are a regular occurrence, rather than an indication of a major catastrophe.
