As the alerts flash on the screen and CNBC talking heads show their excitement for a break from the mundane news cycle, many may be wondering what in the world is happening in the stock market. The global stock markets started selling off late last week and appear to be continuing today (Monday, August 24, 2015) with the S&P 500 around the “correction” territory (defined as 10% down from the peak). As always, there are many factors that go into the financial markets, but it is helpful to first take a look at market history when viewing the current events.
As you have probably heard in the past, market volatility is part of the investing experience. We all wish that we could earn high returns with no volatility, but volatility is exactly what allows for, even produces, these returns. While we all have read newsletters, heard radio ads, and seen other “trading strategies” that promise high returns with no risk, these have a lot of fine print…we all wish it were that easy. The way some investors navigate this reality is to stretch their time horizon out to five or more years and potentially dampen the volatility by adding less volatile pieces to the portfolio. Using proper asset allocation* as a strategy to mitigate risk and pursue needed returns has historically stood the test of time. Yet this method seems unnecessary when markets are soaring (like the past 6 years) and less comforting when markets are selling off (like today).The reason it feels less comforting when markets are selling off is that the dampening is only partial, you still experience some of the pain of the market decline. Investors often begin to question if staying in the market is the right choice, or if they should sell and wait for things to get better. Although this can be tempting when emotions are running high, market history is clear that selling off has historically not been a winning strategy.
If you study the history of the market, you will see that over the last 35 years the average intra-year drop of the S&P 500 is 14.2%, yet annual returns have been positive in 27 out of 35 years. If your strategy is based on avoiding negative volatility, then the stock market seems like a very unfriendly place. However, if your strategy is based on the knowledge that volatility is a necessary part of pursuing higher returns, then you might be less concerned and embrace a strategy like proper asset allocation. It is helpful to think of risk like a dial that can be turned up or down based on your situation, but not turned off.
As for the current market drama, it is a bit of a convergence of events that has changed investors’ risk appetite. As with many selloffs, there is not one culprit or a completely new piece of news. It is rather a familiar risk combined with other pieces of data that starts a chain reaction. This time, China’s slowing economy is the straw that broke the camel’s back. China has been slowing for the past several years and although it only accounts for 15% of global output, they are responsible for nearly half of the global growth. The slowdown in China is not new news, but rather a continuation of a trend that has been going for several years. This trend was expected as China’s economy began to transition from being manufacturing-based to a consumer-based. Part of this plan was to have a currency that was priced by the market. But even so, when the yuan was allowed to float and began depreciating against the U.S. dollar, the market had a strong reaction. This reaction has been magnified by the distrust the market has in the data published by China. A lack of transparency with Chinese economic data only fuels the skepticism in times of fear like today.
The U.S. market has also recently been struggling with low oil prices which have now dipped below $40 per barrel (WTI) on fears of a slowing global economy. There are two sides to low oil and right now investors are only focused on the negative. Additionally, the Federal Reserve seemed poised to raise interest rates very soon (many speculated in September), but recent events may actually push that timeframe out as the financial markets come to grip with the recent volatility. For those with fears of interest rate increases, as stock investors sell, they often flee to assets like bonds which drives down interest rates (and increases bond prices). The U.S. 10-year Treasury rate (a closely watched benchmark) has dropped below and is now hovering around 2%. From these few comments, you can see there are two sides to every coin and sometimes temporary pain brought on by adjustments is a healthy part of the market resetting the “new normal.”
We do not pretend that the recent market drawdown is insignificant, but as of now, it is consistent with fairly normal market activity. We have been the beneficiaries of very low volatility for several years now and that lends itself to the sharper reaction by market participants that we see today. The second quarter earnings season is almost over, with 479 of 500 S&P companies reporting earnings. 70% have beaten estimates and earnings did rise 1.2% which is modest, but positive. Keep in mind that this is in light of significant drags from the energy sector and a strong U.S. dollar. Excluding these two factors (energy sector earnings and the dollar’s impact), LPL Research estimates that earnings rose about 12%. This is quite a different picture of the economy than what is currently being propagated on the TV and radio.
The burning question from investors on days like today is “what can we do?” Investors should always have a portfolio that is built with an appropriate amount of risk and expect a bumpy ride. Secondly, recognize that volatility is not only a “necessary evil” but what provides the opportunity for returns that we need to meet our lifetime objectives. Having a long time horizon is the individual investor’s biggest advantage over some institutions and other investors which have to react to short-term market movements. At Bridgeworth, we plan for these types of events and know this won’t be our last, but just one of many over the coming decades. By planning for volatility in advance and removing emotion from our decision making, we hope to continue to help build wealth for our clients over time. If you have questions or concerns about your investments, please reach out to your advisor to discuss further.
Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management.
Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to trough during the year. For illustrative purposes only. *Returns shown are calendar year returns from 1980 to 2014 excluding 2015 which is year-to-date. Guide to the Markets – U.S. data are as of June 30, 2015.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All indices are unmanaged and may not be invested into directly. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
*Asset allocation does not ensure a profit nor protect against loss.