The S&P 500 dropped another 1.6% yesterday and posted its worst three day slide since November 2011. As the S&P is now down 6.8% from a high set one month ago and holding just over a 1% gain for the year, other equity markets have felt even more pain. The Dow Jones is down 1.5% year-to-date, the Russell 2000 Small Cap Index is down 10% for the year, European stocks (VGK) have shed 12% and Emerging Markets (EEM) stocks are off over 2% for the year.
The Street had become accustomed to calm, slowly rising markets over the past 2 ¾ years. But it was only a few years back where the market had absorbed 15% and 19% downdrafts during the year ultimately ending those years in the green (2010 saw a 13% gain even given the 15% correction while 2011 ended slightly higher even after a 19% correction). Unfortunately, volatility is actually considered the norm in equity markets. There is ample historical evidence showing this. Here’s some:
- Since 1928, major U.S. equity markets have averaged about three 5% corrections each calendar year;
- Since 1928, the S&P 500 has averaged about one 10% correction each calendar year.
The fear is now palpable. Half of Nasdaq stocks are off 20% more from their highs, meaning they are already in a bear market. European bourses are getting crushed. The S&P has now pierced its 200-day moving average—an important technical support level. The Chicago Board Options Exchange Volatility Index, a gauge of investor uncertainty otherwise known as the ‘fear index’, rose to a 28-month high on Monday, after surging 46% last week. Given the price action, investors will have to ask if this will be a normal 5-10% correction, a larger 10-20% correction or a full blown start of a bear market. I don’t know for sure. The simple truth is that nobody knows for sure.
Given the uncertainty, however, it is important to attempt to ascertain the cause of the correction. And the truth here, counter to the daily emphatic declarations of direct cause and effect that we read about in the financial press or hear about from the multitude of market pundits on CNBC, it is very difficult to pinpoint any one direct cause. But, I’ll group the potential causes in three main categories: (1) geopolitical; (2) fundamental; (3) economic growth.
ISIS, Ebola Russia/Ukraine, Ebola, the Middle East, even the disappearance of Rodman’s guy Kim Jon Un are all on the list for the current geopolitical concerns. There is no question in my mind that some of these are causing real fear in equity markets. As I pen this update the S&P is up 20 points–for now. But the second that CNBC cuts to another potential Ebola victim, the S&Ps are sure to drop 20-30 handles in an instant. I don’t want to minimize the tragic consequences of the disease. I also don’t want to fully dismiss the potential devastating market impact that this disease could have on equity markets. But at this point, the geopolitical concerns are only generating short-term emotional fear on the market.
As the always acerbic Josh Brown tweeted out earlier in the year, “I’m going to hold off on investing until the Middle East gets straightened out. – guy in 1967 who died broke”. One who either sells the market or sits on the sidelines due to the emotional fear and market hiccups resulting from these issues risks losing out on future profits. To the extent possible, we attempt to leave out emotion from the investment process.
The most important fundamental indicator—the stock market’s valuation which is defined as the price we pay for a dollar’s worth of earnings—shows the market to be only slightly overvalued. Fears about an inflated market are being mostly perpetuated by a high Shiller Cyclically Adjsuted Price-to-earnings ratio. I’ve addressed the blatant weakness of this metric in the past and it’s probably time I revisit it with another blog post. But for now, any reasonable investor looking at traditional valuation metrics could only conclude that markets are only slightly overvalued–which is a good thing. And with interest rates still at all-time lows, this is an even better thing.
As I’d agree that the recent equity price volatility does include some degree of geopolitical and valuation fears (whether legitimate or not), it’s the fear of economic growth—both domestic and abroad—that has me most concerned. Small-cap stocks—proxies for credit conditions and risk appetites—have been under pressure since late summer, prior to the recent drubbing in all types of equities. This has been a somewhat troubling development because these stocks are often thought of as canaries in a coal mine. When lower they are theoretically indicating a slowing of future domestic (only domestic because these stocks aren’t multinational in nature) economic growth. So, it had been advisable to pare exposure to the small caps. We did this where there was a need. But diversification purposes require us to have some exposure to these stocks. Furthermore, the Fed’s transition to a tighter monetary policy (i.e. raising interest rates) often times causes short-term dislocations in markets. With the realization that the Fed might tighten rates as early as Spring ’15 came a natural knee jerk sell off in equities. Those equities that are sold tend to be the ones that have appreciated the most. This can continue, but it’s mostly a short term phenomenon, which leads us to be a bit more optimistic about the small cap sell off and less of a contributor to long run worries about the domestic economy or stock market.
We’re less optimistic about last week’s developments in Europe. Gavyn Davies of the Financial Times describes it as such, “Financial markets caught a nasty chill last week, when extremely weak activity data from Germany coincided with fears that the ECB could not overcome Bundesbank opposition to more aggressive quantitative easing. Then the IMF reported that there is a 40 per cent probability of a recession in the euro area within 12 months, along with a 30 per cent chance of outright deflation. Markets fear that policy makers in the euro area are once again losing control over their weakening economy.
Since markets often sniff out impending trouble before economists do, there is, as Martin Wolf warns, no room whatever for complacency. But, so far, the blip in global risk assets hardly registers on the Richter scale. Nor is there much evidence from published data of a major slowdown in global GDP growth up to now.”
Davies continues in the piece (which you can read here) to debunk the risk of the Eurozone causing a global recession using sound and thoughtful analysis. However, what is discounted in this analysis is the shockwaves that can be caused by a lack of confidence due to another recession & a seemingly impotent central bank. We’ve seen massive amounts of selling in the past due in similar conditions. Therefore, I’m more concerned about the impact of Europe both on European equities and equities of all geographies (including domestic).
We always maintain an exposure to European equities in client accounts. This is prudent from a diversification standpoint. And earlier this year we slightly increased exposure as we were hoping to see either higher growth in the Eurozone or for the European Central Bank (ECB) to commit to an aggressive Quantitative Easing-like stimulus if this growth could not be achieved. It appears that growth, at least for the time being, is stalling and that the ECB will have a very difficult time corralling the necessary countries to add similar stimulus that the U.S. Fed enacted several years ago. These developments are concerning.
What to do now
Remember, at this point the S&P is about flat for the year even after a 7% correction. These corrections are normal. But it is also true that the complexion of the market has certainly changed. The uptrend and “buy the dip” mentality has been broken. As I previously mentioned, nobody knows for sure where the market will bottom out. In our view, it is time to get more defensive in the face of this recent uncertainty. We have been reducing equity exposure to Europe and small cap stocks. Extra cash is sitting on the sidelines waiting to be deployed.
At the same time, we’re about to enter a very favorable season for stock performance and market prices are now clearly oversold. Valuations are still reasonable (more on this in a future blog post) and interest rates are ridiculously low (even if they go up dramatically from here). Furthermore, the Fed isn’t completely out of the game. Federal Reserve Vice Chairman Stanley Fischer said the other day, “If foreign growth is weaker than anticipated, the consequences for the U.S. economy could lead the Fed to remove accommodation more slowly than otherwise.”
Investors who have aggressively timed markets over the last 6 years (and throughout investment history) have sacrificed future profits. We prefer to maintain a more defensive positioning in times of great uncertainty, but still maintain healthy investment levels appropriate for a client’s risk profile.
Please write or call if you should have any questions.