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S&P 500 DROPS 5.5% IN JANUARY

John Gorlow | Feb 22, 2016
IMF SEES “GREAT CHALLENGES” AHEAD
 
Let’s start with the good news. Global stocks surged on the last trading day of January to finish with their biggest one-day gain in almost 5 months. The Dow, the S&P 500 and the Nasdaq each jumped 2.5%. Asian stocks climbed 1% after Japanese policymakers lowered interest rates and European stocks followed suit.  
 
Of course that was only one day. Despite large gains in the last two weeks of the month, global stocks finished January with heavy losses. The Dow and S&P 500 finished January down 5%, while the Nasdaq dropped almost 8%. The small-cap Russell 2000 Index finished January down 9%. Outside the US, international developed markets as measured by the MSCI World ex US index lost 6.8%. And developing markets, measured by MSCI’s Emerging Markets index, lost 6.5%. 
 
By month’s end, the Dow and S&P 500 each had fallen 10% from recent peaks. The small-cap Russell 2000 index entered a bear market, sliding 20% in the last six months, as did MSCI’s World ex US Index.  The MSCI Emerging Market Index fell to its lowest level since 2009.
 
In other sectors, the Dow Jones US Select REIT Index dropped 4.0%. The Bloomberg Commodity Index declined 1.7%, and gold shares jumped 4.6%. 
 
The yield on the 10-year US Treasury note fell to 1.9%, a multi-month low. Barclays US Aggregate Bond Index returned 1.4%, Barclays US High Yield Index lost -1.6%, and Barclays Municipal Bond Index returned 1.2%. 
 
Overall, the American economy finished 2015 on a flat note, expanding at an annual rate of just 0.7% in the fourth quarter of last year. The economy grew 2.4% for the year as a whole, identical to the pace recorded in 2014 but considerably better than the 1.5% gain in 2013.
 
Warning of great challenges for the world economy, the International Monetary Fund downgraded its forecast for 2016 global growth to 3.4% this year and 3.6% next year. The US economy is projected to grow at 2.6%. 
 
WHAT SPOOKED THE MARKETS? 
 
Since global stock markets began falling at the beginning of the year, the biggest daily price drops have coincided with bad news from China or falling oil prices. Alan Blinder, former Vice Chairman of the Federal Reserve, believes “the market is probably overreacting to news from China by a wide margin. In the case of oil prices, it seems to even to have the direction wrong.” (Wall Street Journal, 21-January 2016). 
 
“China is not as big a deal to the US economy as traders think,” he says, pointing out that exports to China made up less than 1% of US GDP. What if things got much worse, and Chinese purchases of U.S. products dropped by as much as 10%? “Even such an extreme event would cut U.S. exports by less than 0.1%, an amount beneath notice,” he says. 
 
If weakness in China damaged other nations that rely heavily on exporting to China, causing them to buy less from the US, “That would still cut less than 0.2% from the U.S. growth rate,” says Blinder. “More severe outcomes are possible, but unlikely.” 
 
And yet, we’ve all seen how fear in financial markets can be contagious. Didn’t US markets follow the declining Shanghai stock market (though not as steeply)? “Aside from psychology, this is slightly nutty,” Blinder says, explaining that the Chinese stock market bubble was huge and destined to burst, and U.S. holdings in Chinese stocks are “relatively small.” 
 
In regard to falling oil prices, Blinder points out that when the price of things we rely on go down, that’s a good thing. “While falling oil prices are terrible news for Texas and North Dakota, in general they should help, not hurt, U.S. growth,” he says. 
 
A LESS SANGUINE VIEW
 
Paul Krugman is not so certain that China’s woes will cause little or no harm. While acknowledging “…the numbers don’t seem big enough” to cause a global crisis, Krugman admits that he “lacks the courage of my complacency.” 
 
What concerns him: “Global contagion often seems to end up being worse than hard numbers say it should…. If China does deliver a bad shock to the rest of the world, we are remarkably unready to deal with the consequences.” 
 
Krugman’s worries that business cycles across nations are “often more synchronized than they ‘should’ be” if one looks only at the numbers, and psychological contagion could have a crippling, disruptive effect on other economies. If that happens, he notes that US monetary policy would be a limited tool with near-zero interest rates, and there’s no political appetite for a stimulus package from either Europe or the US. In other words, no easy fixes.  
 
Billionaire investor George Soros goes even further. He sees a China slowdown, falling oil prices and currency devaluations adding up the possibility of worldwide deflation, which investors are ill prepared to handle. Of course, Soros has a dog in the fight. He’s betting on US Treasuries, and against the S&P 500 and Asian currencies. 
 
WHAT DOES JANUARY TELL US?
 
Punditry aside, what does January suggest about your investment returns for the remainder of the year? After all, the first two weeks of January were the worst start to the year for the S&P 500 in history, with the index returning −7.93% from January 4–15. 
 
Here’s what the historical data data shows: A negative return on the S&P 500 index in January has been followed by a subsequent 11-month positive return 59% of the time, with an average return of 7%. In other words, a negative January does not predict poor market returns for the rest of the year.
 
What about those steep 10% market declines? From the previous high on November 3, 2015, through its low on January 15, 2016, the S&P was down −10.43%, its second decline of at least 10% since the beginning of August 2015. And in January alone it slid −4.96%.
 
For perspective, consider US market performance in subsequent one-, three-, and five-year periods following comparable 10% declines. On average, the return of the S&P 500 over each of these time periods has been positive. And it has been greater than the long-term average of 10.02% in half of those time frames. 
 
VOLATILITY IN PERSPECTIVE
 
In market downturns, it’s human nature to search for some type of signal as to what it all means for future returns (or for reasons why it’s all happening). Alternatively, we may assume the current period is somehow very different from how markets have historically behaved, and we should therefore behave differently too. Either way, data analysis can provide perspective.
 
We do have remarkably rich historical data. From January 1926 to December 2015 (90 years), the S&P 500 had a compound return of 10.02% and a standard deviation of 18.85. More recently, from January 2010 through December 2015 (6 years), the return for the S&P 500 has been 12.98% with a standard deviation of 13.09. So the recent period has not necessarily been more volatile than the previous century. 
 
During the so-called “Lost Decade” from January 2000 to December 2009 (10 years), the S&P 500 Index had a compound return of −0.95% and an annualized standard deviation of 16.13. When we continue to look at the data, grouped by decade, we see periods of higher and lower returns as well as period of greater and lesser volatility.
 
Historical data shows that stock prices adjust continually to deliver a positive expected return on invested capital. While the realized return over any period may be positive or negative, all the evidence suggests that markets will go up. As investors, the important thing is to stay disciplined through all the ups and downs in order to capture the market’s expected returns. 
 
As always, my best advice is to remain diversified according to your risk tolerance and stick to a low cost, proven strategy that captures market returns during all time periods. Don’t react to market volatility. It is inevitable, and it will pass.