News or Noise Special Report: Putting Market Volatility into Perspective

Transcription

1 Asset Management News or Noise Special Report: Putting Market Volatility into Perspective By David Fisher, Chief Investment Officer In lieu of our regular News or Noise, this week we wanted to publish a special report on the market volatility that re-emerged last week. After an unusual period of stability that saw U.S. markets remain within a 4% band for six months (the S&P 500 stayed in a range of 2,045 2,135 from February 12 until August 20), volatility broke out last week. As we wrote a few weeks ago, it was inevitable that this period of calm would break, but indicators didn t provide clear direction on which way the market would move up or down. Last week gave us the answer in dramatic fashion down. As we discuss below, the declines are well within historic norms, but given the long period of calm, we understand and appreciate the anxiety that the volatility can cause for investors. We wanted to touch on a couple of the key questions that clients and contacts have been asking our team. What Caused the Market Pullback Last Week? There has been a growing list of concerns over the summer: renewed weakness in oil and commodity prices, lingering fears about Greece, and political and military tensions in Russia, the Korean peninsula and the Middle East. But concerns about China are responsible for the change in investor attitudes that occurred over the past few weeks. The causes and the consequences of the Chinese yuan devaluation continue to be unclear. Is the slowdown in China progressing along a path that leaves policymakers out of control? Will other countries retaliate with weaker currencies to block the effects If China stabilizes, the challenges in other emerging markets are not enough to cause a global recession. from China, causing an all-out currency war? And most importantly, is there stability within the political elite of the Chinese Communist Party? It is this last question that is especially worth pondering. 1

2 We continue to believe that a cohesive government in China has plenty of tools at its disposal to engineer a controlled slowdown in the country and, most importantly, provide a foundation under the banks and the credit system. The New York Times published a piece over the weekend 1 that highlights the growing sense of unease among senior party officials in China. A political crisis in China would change all scenarios for the global economy. At this point, the direction of the market likely hinges on a binary event a Chinese hard landing or not. The China story is also directly related to the broader emerging-markets story, which is the center of the current crisis. Broad emerging-market indexes are down 16% year-to-date. Latin American stock markets are down more than 25% on average. And the Dow Jones/UBS Commodity Index broke below the 2009 lows and is now trading at levels not seen since Much of the concern is being manifested in the currency markets, with many emerging-market currencies down more than 20% on the year. But we continue to believe that China is the fulcrum market. If China stabilizes, the challenges in other emerging markets are not enough to cause a global recession. Why Did the Pullback Happen Now? With much of the world on vacation, one would expect that markets would stay calm until at least early September. However, sometimes the summer lull can create its own drama, as the reduced volume of trading can exaggerate moves that would be modest if more market participants were engaged. We don t frequently reference Mad Money host Jim Cramer in our writing, but he had an interesting observation last week connecting the recent market declines to the August 4 earnings disappointment for Walt Disney Company. The effect, he said, was that investors took off their rose-colored glasses and collectively realized that everything is not perfect. If investors can change perspective on a powerhouse company like Disney, maybe they need to look more skeptically at lots of things and this is what they have been doing over the past few weeks. Certainly other dates on the calendar likely bear as much or more responsibility. The yuan devaluation of August 11 injected new risks and greater volatility. There is also the upcoming Fed meeting on September 17, which many still expect to include the first Fed rate hike in more than eight years. Even with knowledge that a correction is inevitable, timing these shifts in investor attitude is nearly impossible. How Does This Volatility Compare with Historic Market Movements? First, it is important to define a few terms. Generally, investors consider a correction to be a drop of 10%, and a bear market to be a decline of more than 20%. By these definitions, we don t believe a correction has yet to occur, since the S&P 500 is down 7.6% on a closing basis (Friday), though a broader look at global markets shows that most including even the Dow Industrials and small caps in the U.S. have eclipsed that level as of Friday. In October a similar sharp drop left the S&P 500 with a decline of just under 10% also not a technical correction. The last time the S&P 500 actually declined 10% was in May 2011, and this run of more than 1,400 days is the third longest streak on record. 2

3 Thus by most accounts the market is certainly overdue for a correction, and history would also show it could continue a little longer. The chart below from JP Morgan shows intra-year declines in the S&P 500, and from this visual we can see how unusually calm the market was before the last few weeks. Even the 8% decline we have witnessed is on the historically mild side, with the average intra-year decline over the past 30 years calculated as 14% and the median decline as 10%. Statistically, if 2015 ended Friday, the year would end in the top 25% of least negative market years. So based on history, the recent volatility is very mild. But given the period of relative calm, investors are definitely more sensitive to the volatility, and we will thus work to continue communicating our views in a timely fashion. It is also important to realize from the data that periods of volatility tend to come in waves and that they tend to occur after periods of calm, putting the current markets in a higher risk zone. Is SignatureFD Making Adjustments to Strategy? We are certainly watching closely, but we are not yet ready to call for a shift in strategy. We are working with all of our internal and external resources to determine if anything approaching a bear market is likely. Even after Friday, this doesn t appear to be the case. It is critical for investors to realize that timing any portfolio changes to try to capture modest corrections is fraught with danger. Often, these can be quick pullbacks with sharp rebounds, leaving an investor harmed after selling positions and then re-entering. It is a truism that long-term investors have to get two trades right to make money in these cases selling early enough into a correction and then buying back at a lower level. If unable to execute on both, investors do permanent harm to their compounded wealth. (This doesn t even take into 3

4 account the tax realizations that can also occur.) The market pullback in October 2014 is a recent example of this. Over the course of seven days, the market corrected just more than 8%, but then it recovered all of these losses within nine days and went on to new record highs in just 16 days. It is also important to differentiate between long-term bull markets and structural bear market periods. Given the strength of the market since 2009 and the length and amount of previous record highs, it is almost a certainty that we are in a structural bull market. In these periods, market corrections tend to be much quicker and less damaging. This means that investors should be careful about trying to shift allocations too aggressively, or they risk losing out on some of the long-term growth. If the data over the coming weeks give an indication that the bull market could be ending and a powerful and structural bear period could be unfolding, then more dramatic action will be warranted. As our partners at Ned Davis Research reiterated last week, the bull market deserves the benefit of the doubt until the weight of the evidence turns. It remains likely that the period of recent weakness will turn and shift to a period of strength into year-end. What Are the Key Issues to Watch for Going Forward? The message so far: (1) It is too hard to try to time corrections within bull markets; (2) the current environment still seems to be a bull market for developed economies; and (3) be ready to change your mind if (1) or (2) is wrong. But how will we know? Unfortunately, there are no easy answers to that question. But understanding the key fundamental issues at work in the global economy is where to start. For a broader bear market to unfold, it will likely take a dramatic worsening in trends and a financial mechanism to create a systemic crisis. This doesn t appear likely for three key reasons. First, the developed economies of the world remain in growth mode, with Europe and possibly Japan even showing the potential for acceleration of growth rates. The core of the current challenges is in the emerging-market complex. As China slows and the U.S. moves closer to the Fed raising rates, many emerging markets are being confronted with multiplying challenges of reduced receipts from commodities, outflows of investment dollars, and weakening currencies making any dollar-denominated debt more expensive. But even with China s growth slowing, it is likely the country will see an expansion of gross domestic product by 6% this year. India should see similar growth. Thus, aside from the commoditysensitive countries and a few fragile yet smaller economies, growth is still likely to hold up over the next year. Second, the currency policies that led to the emerging-market crisis in the late 1990s have been largely improved. Before 1998, many countries had outright or partial currency pegs. As economic pressure built up over time, these countries could no longer defend these levels, and immediate, sharp currency devaluations occurred, causing economic turmoil within the countries. At the current time, most of these countries have free-floating currencies, which allow for more gradual and modest adjustments to occur. 4

5 Finally, global valuations remain fairly attractive. U.S. markets have risen significantly in recent years, and domestic stocks remain, arguably, overvalued. But outside the U.S., most markets have lagged by a wide margin in recent years and, in many cases, are also underperforming so far in That leaves these markets with attractive valuations, which should start to induce investors to place capital to work. So with the above as a backdrop, we will be watching for three critical items over the next few weeks. First, will currency markets begin to calm down? Second, will a social or political crisis occur in China? Finally, will real-time indicators give concern that the global economy could be tipping into recession? We have portfolio shifts ready if any of these occur. However, we also have shifts ready in the event the current volatility passes and a year-end rally becomes the most likely outcome. Sources 1. Michael Forsythe and Jonathan Ansfield, Fading Economy and Graft Crackdown Rattle China s Leaders, The New York Times, August 22, 2015, world/asia/chinas-economy-and-graft-crackdown-rattle-leaders.html?_r=0. What Is News or Noise? Like most of you, we are inundated with information on our phones, in our inboxes and on the Internet. Clearly, the world doesn t need another investing blog to reprocess stale information or reformat the day s useless headlines. Thus, in our investment blog, News or Noise, we ve taken up the challenge of sorting through the infinite bits of background noise and seeking the few truly newsworthy nuggets of information. What are the stories today that are likely to be meaningful for investors in the future? A very small number of headlines are important, and of those, many are immediately processed by investors. Only a tiny fraction of all the new data is truly relevant and underappreciated. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by SignatureFD, LLC), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from SignatureFD, LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. SignatureFD, LLC is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the SignatureFD, LLC s current written disclosure statement discussing our advisory services and fees is available upon request. 5