One of the fundamental concepts in behavioral economics is the prospect theory, which postulates that the pain of a loss is more significant than the anticipation of a gain. This theory, developed by Daniel Kahneman, a Nobel Prize winner in Economic Sciences, was evident on Thursday as the S & P 500 experienced a significant drop in the final hours of trading.
On that day, President Joe Biden had a conversation with Israel’s Prime Minister Benjamin Netanyahu, urging an immediate ceasefire in Gaza and increased protection for aid workers. Additionally, reports surfaced about Israel preparing for potential retaliation from Iran, causing bond prices to rise, yields to decline, and oil to rally.
Later, Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, pondered the idea of cutting rates if inflation remains steady. Despite the declines on Thursday, the S & P 500 remains only 2% below last week’s record highs. The surprising aspect is not the drop on Thursday, but rather the overall stability the index has displayed.
The S & P 500 has seen consistent growth for five consecutive months, primarily due to stable earnings expectations for the first quarter and the rest of the year. While estimates for first-quarter earnings have decreased to a projected gain of 5.1%, down from the initial 7.2% at the start of the year, analysts have made smaller cuts than usual to these estimates.
For a more significant drop in stocks to occur, there would need to be a substantial miscalculation in earnings estimates. Factors contributing to this could include a notable economic decline, a sustained increase in interest rates, or an unexpected external shock. Currently, the first two scenarios are not unfolding, and the possibility of a 10% or larger drop in the market seems unlikely without significant economic deterioration.
Market declines of 10% or more are not uncommon, happening in 50% of the years between 2002 and 2021, with an average pullback of 15%. Despite these fluctuations, stocks have typically seen positive returns over time. Therefore, it is crucial for investors to be prepared for potential volatility in the market and avoid falling into the trap of assuming continued upward momentum based on recent performance.
Behavioral economics is based on the prospect theory, which states that the pain of a loss is greater than the expectation of a gain. This was evident as the S&P 500 dropped 100 points in the final hours of trading due to various factors such as President Biden calling for a ceasefire in Gaza and potential retaliation from Iran. Despite this decline, the S&P 500 has been steadily rising for the past five months, largely due to stable earnings expectations. While first-quarter earnings estimates have decreased slightly, analysts have not made significant cuts. In order for a more significant drop in stocks to occur, market participants would need to believe that earnings estimates were significantly off. Factors that could lead to a bigger decline include a notable decline in the economy, a sustained spike in interest rates, or an unexpected shock. While job growth remains strong and there is no sustained spike in rates, unexpected shocks like geopolitical tensions can impact the market. Despite common concerns about economic weakness or shocks, market declines of 10% or more are actually quite common. A study from Charles Schwab found that such declines occurred in half of the years between 2002 and 2021, with an average pullback of 15%. Therefore, investors should not be surprised by notable declines in the market and should be prepared for such fluctuations.
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