Market Pullback A Q&A with our Investment Team

Transcription

1 Market Pullback A Q&A with our Investment Team The Morningstar Investment Management group August 2015 Last week, stock markets fell globally in the toughest week of 2015 to date. Investors weighed concerns over China, the potential for interest rates to rise in the U.S., and rocky emerging markets. Below, read more about what we think matters most to investors and how they might respond. Dan McNeela, CFA Senior Portfolio Manager The opinions expressed in this article are those of the author and do not necessarily reflect the positions of Morningstar, Inc. and its subsidiaries. The information, data, analyses, and opinions presented herein do not constitute investment advice; are provided solely for informational purposes; and therefore are not an offer to buy or sell a security. This document contains certain forwardlooking statements that involve known and unknown risks, uncertainties, and other factors that may cause the actual results to differ materially from any future results, performance or achievements expressed or implied by those projected in this document. As of market close on August 21, 2015, the S&P 500 Index declined 6.9% from its late-may peak, while most other global equity indexes have experienced steeper losses from their respective 2015 highs. For instance, U.S. small cap stocks (Russell 2000 Index) have dropped 10.3% since late-june, while equity markets outside the U.S. have also fallen significantly from their earlier-year peaks. Emerging-markets equities (MSCI EM Index) have been particularly hard-hit, dropping 22.8% since late-april, while non- U.S. developed equities (MSCI EAFE Index) have lost 8.9% since late-may. Meanwhile, oil prices have continued to plunge in recent months, and commodities markets (Bloomberg Commodity Index) have experienced a 16.4% pullback since mid-may. Given the elevated levels of volatility and turmoil in the markets, we think it s a good time to address a few key topics and summarize our views. Why did this happen? In short, China. The broad U.S. equity market, which reached record-topping levels in early spring and summer, suddenly plummeted on August 17, with the rout continuing ever since. Fears that world s second largest economy is slowing dramatically appear to be behind the sell-off. Beijing s unexpected decision to devalue its currency on August 11 first raised red flags; weak economic data in the weeks following have further raised alarm. As seen this past week, China s global importance means any disruption to its economy reverberates around the world. Does this mean we're entering a correction? A correction is typically defined as a decline of at least 10% in a stock, bond, commodity, or index. Generally, it is a temporary price decline within a bull market, but it can be a precursor to a bear market. The Dow Jones Industrial already suffered a 10% plus decline. The Index peaked at 18, and closed on Friday at 16, (a 10.12% decline). The Dow also opened sharply lower on Monday. So, yes, it does appear that we ve entered correction territory.

2 Page 2 of 5 Are stocks still overvalued? The bull market had been getting long in the tooth, and overall valuations were looking rich. As of Friday, August 21, the S&P 500 had rallied for 1,418 days without a 10% correction, the third longest rally since the index s inception in As of this morning, the streak looks to be in jeopardy with this morning s price (1928) down nearly 10% from its peak of on May 21, In our view, the overall market appears closer to fairly valued as of this morning. History tells us the price of the market can swing sharply in both directions, from overvalued to undervalued--especially over shorter time frames. One valuation measure we like to monitor is the Shiller P/E ratio, which compares the S&P 500 s price to its 10-year average of inflation-adjusted earnings. As of March 31, 2015, this measure stood at This morning the ratio is down to 24.1, which is right near the average over the past 25 years and modestly above its average of 19 since Another measure of overall market valuation is the S&P 500 s trailing price-to-earnings ratio, which stands at 16.9 as of this morning versus a long-term average of 16.4 (going back to 1954). While it s natural to focus on the stock market s daily price action, especially in periods with greater volatility like today, we think investors can't afford to get caught up in emotion, or lose sight of their overall longer investment time horizon, even when the ride gets bumpy as it has been over the past week. What about the price of oil? U.S. crude oil prices dropped below $40 per barrel in early-morning trading on August 24, down more than 50% from a year ago. The first leg down in oil prices was caused by increased supply and Saudi Arabia s decision in late 2014 to let prices fall further by increasing production instead of trying to prop up prices by cutting back. A few factors have contributed to the near-term fall in oil prices, which started in mid-july Data showed oil production has remained fairly high despite the new low-price environment and the Iran nuclear deal could lead to additional supply. The most recent negative surrounds the potential for weaker demand due to further slowing of China s economy. China is the world s second largest consumer of oil, behind the U.S., and has been a key source of increased demand for oil in recent years. That said, lack of demand does not appear to be oil s main problem. In August, the International Energy Agency raised its 2015 forecast for global oil demand to growth of 1.6 million barrels per day for the year, with additional demand growth projected for Should investors worry about the prospect of rates rising quickly? Yes and no. In the near term, we re not overly concerned about rates rising quickly. It s true that the Federal Reserve has been inching toward a rate hike, with the market recently forecasting a 50/50 chance of a move higher in September. But the Fed s primary impact is on the very short end of the yield curve through the federal funds rate. Longer-term rates are largely determined by market forces, and the most recent move down in commodity prices is likely to further dampen inflation fears. As a result, longer-term rates have moved lower, not higher. That said, our longer-term forecast is that investors should account for the possibility of higher rates in the future. Global rates remain near

3 Page 3 of 5 historic lows and the global economy has been slowly getting back on its feet. Investors aren t getting paid much to take on a lot of interest-rate risk. What do you expect to happen next? The future is always uncertain, and markets will always go through periods of high volatility. In the past five years, U.S. stocks have marched steadily higher despite a number of events that have threatened the rally. Several rounds of the euro crisis and the Greek debt crisis, the 2011 debt-ceiling crisis and debt downgrade in the U.S., the 2014 Ebola scare, and Russia s annexation of Crimea, are just a few events that have rippled through markets. And the global financial crisis remains a painful reminder of what can happen in a worst-case scenario. But we think investors are best served sticking to their long-term plan and not giving in to the twin vices of fear and greed. K MSCI EAFE NR USD This Europe, Australasia, and Far East index is a market-capitalization-weighted index of 21 non-u.s., industrialized country indexes. This disclosure applies to all MSCI indices: Certain information included herein is derived by Morningstar in part from MSCI s Index Constituents (the Index Data ). However, MSCI has not reviewed any information contained herein and does not endorse or express any opinion such information or analysis. MSCI does not make any express or implied warranties, representations or guarantees concerning the Index Data or any information or data derived therefrom, and in no event will MSCI have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) relating to any use of this information. S&P 500 TR USD A market capitalization-weighted index composed of the 500 most widely held stocks whose assets and/or revenues are based in the US; it's often used as a proxy for the stock market. TR (Total Return) indexes include daily reinvestment of dividends. The constituents displayed for this index are from the following proxy: ishares Core S&P 500 ETF. Russell 2000 The Russell 2000 Index offers investors access to the small-cap segment of the U.S. equity universe. The Russell 2000 includes the smallest 2000 securities in the Russell Dow Jones Industrial Average The Dow Jones Industrial Average, also referred to as The Dow, is a price-weighted measure of 30 U.S. blue-chip companies. The Dow covers all industries with the exception of transportation and utilities, which are covered by the Dow Jones Transportation Average and Dow Jones Utility Average. While stock selection is not governed by quantitative rules, a stock typically is added to The Dow only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. Maintaining adequate sector representation within the indices is also a consideration in the selection process.

4 Page 4 of 5 MSCI EM Index The MSCI Emerging Markets Index captures large and mid-cap representation across 23 Emerging Markets (EM) countries*. With 836 constituents, the index covers approximately 85% of the free floatadjusted market capitalization in each country Bloomberg Commodity Index The Bloomberg Commodity Index is made up of 22 exchanged traded futures on physical commodities. It represents 20 commodities, which are weighted to account for economic significance and market liquidity. Shiller P/E Ratio The Shiller Price-to-Earnings ratio (P/E) uses average inflation-adjusted earnings over the trailing 10-years to determine a P/E for the S&P 500 Index, a widely used proxy for the U.S. stock market. by using 10 years' worth of earnings data in its calculation, the Shiller P/E reduces the effects of temporary market swings in earnings and focuses more attention on how the market's current price compares with longterm earnings trends.

5 Page 5 of 5 Disclosure The information contained in this document is the proprietary material of Morningstar, Inc. and its subsidiaries. Reproduction, transcription, or other use, by any means, in whole or in part, without the prior written consent of Morningstar, is prohibited. Opinions expressed are as of the current date; such opinions are subject to change without notice. Morningstar and its subsidiaries shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. This commentary is for informational purposes only. The information, data, analyses, and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Past performance is not a guarantee of future results. Therefore, this content is not an offer to buy or sell a security and is not warranted to be correct, complete or accurate. The opinions expressed in this article are those of the author and do not necessarily reflect the positions of Morningstar, Inc. and its subsidiaries. This document contains certain forward-looking statements such as expects, anticipates, believes, estimates, forecasts, and similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason. Past performance does not guarantee future results. Indexes discussed are unmanaged and not available for direct investment. 22 West Washington Street Chicago, IL USA 2015 The Morningstar Investment Management group includes Morningstar Associates, LLC, Ibbotson Associates, Inc., and Morningstar Investment Services, Inc., all registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. All investment advisory services described herein are provided by one or more of the U.S. registered investment advisors.