How swiftly summer has transitioned to fall, well, at least that’s what most asset prices are doing – they’re in free-fall.
Last week was a brutal week on Wall Street and for many bourses throughout the world, culminating in the worst week for stocks since September 2011 – the S&P 500 closed down 6.8% last week and down 11.2% from its recent peak of May 21st and off 8% on the year (excluding dividends).
The rout continued into Monday’s trading session, sending the S&P and other indices down 10% + from their recent highs, qualifying technically as a correction. The bull run lasted 1,474 days (without a 10% correction – all days from Aug. 11, 2011 through Aug. 23, 2014), the 3rd longest with 2,553 days from Oct. 1990-Oct. 1997 being the longest.
After a weekend reprieve, stocks renewed their decline after China’s Shanghai Composite plummeted 8.5% overnight in what is being called Black Monday. That spilled over into European and US markets. At Monday’s open the Dow(n) Jones Index dropped 1,000 points with major indices closing down nearly 4% on the day.
World Market Indices (as of August 24, 2015 unless otherwise indicated)
|American Market Indices||YTD %||European Market Indices||YTD %|
|S&P 500 (Large Co’s)||-8.05%||London (FTSE)||-10.16%|
|Russell 2000 (Small Co’s)||-7.72%||Frankfurt (DAX)||-1.60%|
|Asian Market Indices||YTD %||Other Key Indices||YTD %|
|Australia||-7.01%||Gold & Silver||-30.08%|
|Japan (Nikkei 225)||6.25%||NYSE Energy||-25.50%|
Let’s define some terms often bandied about on Wall Street; this graphic I found revealing.A decline of this magnitude is very disconcerting and painful to the value of everyone’s investment portfolios. And, it not only affects equity investments but almost all asset classes as they suddenly move in tandem during times of duress.
Definition of Stock Market Downturns
Joshua M. Brown (The Reformed Broker blog, Aug. 20, 2013)
When I started writing my commentary last week, we were looking at an intra-year decline of 5%, a decline that’s not all that unusual to experience. Interestingly enough, it’s been two decades since we experienced a year without at least a 5% decline (as shown below).
Annual Returns and Intra-Year Declines (data through July 31, 2015).
Numbers in grey are S&P 500 annual returns for that respective year.
Numbers in red indicate the percentage decline from heights of that year.
Corrections of 10% or greater happen with less regularity but aren’t all that rare. In the graphic above of the S&P 500, we can see that over the 35 year period from 1980-2015, there has been 20 intra-year corrections (I’m including ’15 as being one of those years), so the average is 57% (20/35) of the years in the range have experienced a correction. And, often times the index fully recovered its value by year-end. Looking out longer-term, the index fully recovered its value after 10 months, on average.
The take-away on this graphic is that while market drops are worrisome, in the long-term it’s noise and should have no long-lasting repercussions on our life plans. While there’s no guarantee that the length of future recoveries will happen in a similar time frame, unless you have a need for the money in the short term, it’s best to be patient (I know that’s easier said than done).
My response as an investment manager, at this juncture, is not to make any structural changes to portfolios in light of what’s happened. However, I am looking at rebalancing, and investing in companies and security structures that will best ride this storm out, as well as tax loss harvesting where appropriate.
Why the Weakness?
The sell-off appears to be tied to a litany of reasons. First, here at home, there’s increasing uncertainty as to when the Federal Reserve will raise interest rates (referred to as lift-off). Market participants hate uncertainty and there’s confusion as to when rates will rise. My best guess now is that we’re looking at lift-off in January or March 2016, not September, October nor December 2015.
Additionally, as I pointed out in my last commentary of August 7th, the wild card for added uncertainty to global markets was China. Lo and behold, they lowered their currency exchange rate the following Monday, August 10th. That started a chain reaction of emerging market currency devaluations, investors fleeing developing markets and a rout in all things commodity related (US oil now below $38/barrel, 12 months ago it was $92).
Emerging Countries Commodity Connection
It’s been a gut check for global investors already fatigued by a grind of increasing geopolitical issues with which to grapple.
China’s devaluation of the yuan triggered an avalanche of declines in most emerging market currencies which had already been at multi-year lows, particularly given their dependence upon exports of natural resources and China’s slackening demand for these industrial inputs.
Bloomberg Commodity Index (total return of 22 major commodities/raw materials from oil to metals, 5 yr. chart through Aug. 24, 2015. The index is now at a 16 year low, dating back to August, 1999)
From Russia to Turkey and Malaysia to several other countries dependent upon trade with China, or compete against them, or heavily rely upon commodity exports – Brazil, Peru, Mexico, Thailand, Taiwan, Vietnam, South Korea, South Africa and Kazakhstan – all have taken to competitively revaluing their currencies. Where their currencies are free-floating, market forces did this for them. And as the previous graphic on global market performance shows, developed markets aren’t immune to the misfortune of others.
The result of all this competitive currency devaluation game gaining momentum has fast become the new catalyst for the direction of the markets. It reduces demand for U.S. products in all of these developing (and devaluing) countries, subsequently crushing demand for U.S. goods and services and those companies with significant foreign exposure.
The ramifications of these currency devaluations will take months if not a few quarters to sort themselves out. Is the global economic situation all going to hell in a handbasket? No, not really. Some of these shifts have been long coming and are ready to anniversary themselves (the strong US dollar, the downturn in commodities, especially oil). We continue to see the U.S. economic picture improving and Europe rebounding on QE funding, yet all of the headlines are focused on China presently.
While China bears watching given their importance to the global economy, their government has plenty of tools to stimulate their economy. History tells us they are not short on will power, creativity or the cash to restart growth. [My own intuition is to short-sell countries that host the Olympics!]
While there’s no way the U.S. is going to remain an island with so much turmoil going on around the rest of the world, I do not believe that there is good reason for stocks to fall much further than the current losses in the U.S. and in Europe on this one catalyst alone.
Global challenges will obviously persist through year-end and beyond. Based on the experience of past currency wars, while one or the other country may be ahead of the race to the bottom in the short-term, most likely no one will end up being a real winner in the end.
What to Do?
Stock market volatility has immediately escalated after several years of calm. Geopolitical conflicts, the ongoing Euro area crisis, central bank policies and the age of this business cycle are but a few reasons investors are nervous today. Overreacting to short-term news and normal market movements often leads investors to inappropriately alter their asset allocations, potentially harming their ability to achieve long-term investment goals. Rather than fear volatile markets, investors should maintain their composure by staying focused on long-term economic and market expectations.
As JP Morgan’s recent commentary pointed out, there are three simple principles that can help investors maintain this balance – by keeping market volatility in perspective; focusing on longer investment time horizons; and maintaining portfolio discipline. While the past is clearly no guarantee of the future, investors who can see beyond short-term volatility will make better investment decisions.
Volatility in Perspective
Volatility is unavoidable in investing. There are many technical measures of market volatility, but for long-term investors the most meaningful measure may be the largest intra-year declines experienced.
These declines can occur over days, weeks or months but often happen swiftly. I often think of positive returns being earned in a stair-step fashion up, but declines happening like an Acapulco cliff dive.
Having the fortitude to stay invested during these periods requires discipline that has, more often than not, been rewarded. For example, the maximum drawdown of 5.8% in 2013 occurred when the Federal Reserve began hinting at reduced asset purchases. 2014 saw a similar market pullback, when the market fell 7.4% during October over a variety of global concerns. Despite the negative market reactions and subsequent volatility, neither episode was in reaction to underlying economic growth trends.
Consequently, those who stayed invested during each period benefited from subsequent market rebounds. Not only did the market recover in each case, but these intra-year pullbacks also rank as two of the shallowest on record since 1928.
The S&P 500 is currently back down to October 2014 levels. Against a longer time horizon, the recent drop looks more like a downward bounce within a consistent range rather than something more ominous.
Although volatility is unavoidable, it is a reason for investors to maintain a long-term perspective rather than a reason for pessimism. After all, an investor’s sensitivity to market volatility is largely determined by his or her investment time horizon, and U.S. equity markets have rewarded those who have stayed invested over longer periods of time.
The volatile and asymmetric returns experienced over days and weeks are smoothed over during the course of months and years. Thus, overreacting to short-term volatility is likely to backfire. Monthly returns improve upon daily returns with 59% of months experiencing gains. Annual returns are better still. Since 1928, 67% of years have seen positive returns, with average gains far outpacing losses (according to JP Morgan analysis).
Focusing on the Long Term
In addition to focusing on months and years rather than days, investors should also consider longer investment horizons. Over any 1-year period, the S&P 500 has experienced gains as high as 51% (in 1954) and losses as low as -37% (in 2008). Clearly, an undiversified equity portfolio is inappropriate for short-term goals.
Simply expanding to a 5-year holding period improves the risk/return profile of stocks dramatically, with the worst 5-year period since 1950 experiencing only a 2% decline. Most important, there has never been a 20-year period in the postwar era that has experienced losses. While this is no guarantee of future returns, it demonstrates the importance of specifying the right time horizon to minimize portfolio risk. Clearly, investors who can see beyond short-term market volatility by expanding their time horizons can benefit from broad market and economic cycles.
Maintaining Portfolio Discipline
Stock market volatility can be managed in a portfolio by following a disciplined diversification and rebalancing investment approach. By diversifying and rebalancing properly, solid returns and lower volatility is obtained in a portfolio with multiple asset classes (see the exhibit below).
Portfolio Diversification and Rebalancing can Provide Greater Stability in Volatile Markets Asset Class Returns (2005 – 2014)
Investors should keep market volatility in perspective, invest over longer time horizons and maintain portfolio discipline. Those who can see beyond short-term volatility by focusing on these three simple principles will likely be rewarded for their patience and discipline.
I think that when the dust settles, we’ll see that the swift downturn looks less like a catastrophe in the making and more like a much-needed breather.
The big question now is whether the fundamentals driving the recent sell-off get worse or settle down. This matters a lot for businesses and individuals in China and other countries under stress, and for oil/commodity producers globally. But for the United States economy and even for most companies traded on American exchanges, it’s much less clear that it should create a more protracted downturn.
Consider that in 1997 and 1998, an emerging markets crisis (the Asian Contagion) rippled across East Asia and Russia. In 1998, the S&P sold off by 19% but ended the year up 27%. That year and next turned out to be gangbuster years for U.S. economic growth and corporate earnings and correspondingly market returns. Market downturns were like holes that were excavated, then quickly backfilled.
As a steward of your money, I recognize something that many people seem to forget – economies and markets have cycles, and their record for coming out of downturns is 100%. Downturns are where bargains come from. Volatility is an outward manifestation of fear, and it is rarely the case that a market is both afraid and extremely overvalued (although that may be the case in China).
In the meantime, the best response for most investors trying to grapple with the latest bout of volatility is to take a deep breath. Now is a time to invest with composure and to rely on the power of diversification.
I’m still optimistic that this correction will be short-lived and that the 4th quarter will treat investors to better days ahead even if that means getting back to even or slightly up on the year.
Wishing you good health, wealth and prosperity. And add to that, patience.
Eric J. Linser, CFA
August 7, 2015