Equity markets plunged late last week and the selling continued on Monday. The S&P 500 was off 3% on Friday and down nearly 4% after Monday’s close. At one point during Monday’s trading the DJIA was down over 1,000 points, but it ended up down only 588. Both the S&P 500 and the Dow have declined by more than 10% since reaching record highs in May. That is correction territory, while a decline of 20% or more signals a bear market. Foreign equity markets have performed poorly as well, especially the emerging markets. Treasury bond prices have rallied and yields have fallen on a safe haven bid and flight to quality. What is going on and what should investors do?
What is going on?
The confluence of a number of events have sparked this recent sell off. First and foremost, the Chinese economy has begun to slow down. After having grown at an annual rate near 10% for several decades, growth recently has been closer to 7% and even that number has been questioned as unrealistic. China was a locomotive for global economic growth pushing up many commodities and other emerging market economies in particular. Recently, stock market volatility (the Shanghai index soared early in the year (+60%) and has plunged recently right back to where it began in January) and the decision to devalue the yuan has unnerved investors. The devaluation was a surprise as the yuan was tied to the dollar and had been appreciating over the years, making Chinese goods more expensive. The explicit devaluation raised questions about just how bad the slowdown in the Chinese manufacturing sector might be. We think the Chinese authorities still have levers to pull. They are all about growth so as to ensure “social stability.”
Commodity prices have collapsed in many markets. We know oil prices have fallen by more than 50% and WTI now trades at around $38 dollars a barrel. Other commodities have also been pummeled. The broad based Bloomberg Commodity Index is back down to where it was in 1999. Slowing demand growth and a glut of supply are the catalysts. That obviously hurts commodity producing companies and countries – like Brazil and Russia and Saudi Arabia. But it does help consumers, especially from the US, Europe, and Japan. So far the pain from lower prices has prevailed but sooner or later lower prices will encourage consumption and spending. The drop in commodity prices has been deflationary and consumer prices have been tame throughout the globe – which helps keep interest rates low.
Global growth in general has been disappointing. The US expansion is the weakest since WWII and despite forecasts of more normal 3% growth, 2% is about the best we can do. Europe is in recovery but growth is in the 1% range and Japan is also at 1% despite substantial monetary stimulus in all three countries. The Federal Reserve seemed poised to finally raise rates in September, but that may be put on hold given the current volatility. The emerging markets are also slowing and their currencies depreciating in efforts to grab market share via export growth. It’s possible that the debt binge just before 2008 has still not been worked off, though that is more of a problem for governments than it is for consumers or financial institutions (as much of that debt has been worked down over the past few years).
Going into last week equity market valuations were high, but not extreme. They weren’t in a bubble partly because earnings were at record levels in the US (albeit flattening), and improving in Japan and Europe. But there was not much “margin for error”; not much of a cushion was built in to absorb bad news. Given the selloff, valuations are looking better (than average) on an absolute basis and certainly on a relative basis versus bonds and the current low inflation environment.
What to do?
George Goodman (pen name “Adam Smith”) once warned, “If you don’t know who you are, the stock market is an expensive place to find out.” We know our clients are in the right asset allocation for the long term based on their individual needs, wants, and tolerance for risk. Usually resetting strategic portfolios in the middle of a short term market decline is NOT a good idea!
Remember, we have been here before. No, I’m not talking about the panic of 2008. That was a one off event caused by massive leverage in the financial system and a bubble in US housing. But corrections and bear markets are normal and market volatility is the price you pay for being in stocks rather than bonds. Now bear markets are almost always accompanied by a recession and the US does not appear to be in any danger of that. Employment growth is steady, housing and car sales are picking up. The consumer has been cautious and saving more. It is a bit of a mystery as to why the consumer has not been spending their windfall that has come from falling oil prices. Interest rates are low and the banking system is in fine shape. Emotions and volatility are running high, but at least with respect to the US the fundamentals haven’t changed much at all. They are ok.
APCM managed portfolios are well diversified. They are not the Chinese stock market! In fact in client portfolios Chinese stocks are only about 1% of assets! Most portfolios we manage are down 2% to 4% in 2015 as of the close on Monday, depending on the equity allocation. Not bad given the market volatility of late. Most diversified portfolios have seen significant gains over the past six years that dwarf the recent declines. That helps puts things in perspective.
Remember the quote from Benjamin Graham: “In the short run the market is a voting machine. In the long run it’s a weighing machine.”
The sun will come out tomorrow – or the next day! These declines are temporary. We encourage clients not to make them permanent by selling now. We know from experience that market timing usually doesn’t work. You might sell and watch the market go down some more and feel lucky (maybe even smart), but I suspect you won’t get back in in time to capture the rebound. Study after study shows this kind of investor behavior is self-defeating.
Jeff Pantages, CFA®
Chief Investment Officer