Market Update: Sep 2, 2015

Over five trading days between August 17 and August 24 the United States stock market plunged 10%, with similar or greater drops in other countries. Worldwide, the drop left 18 of 49 stock markets tracked by MSCI in bear market territory, down 20% from recent peaks. But the ride wasn’t over. By August 28 stock markets in the US, Europe and the UK were back to where they started the week. Markets then headed lower at the end of the month amid heightened unease over China and uncertainty over the US monetary outlook.

Overall, global stock markets in August suffered their worst monthly performance in more than three years. The S&P 500 finished the month down 6.26%, leaving the index off 4.21% YTD. The Dow ended the period down 6.57%, bringing it down 7.75% YTD. The MSCI international developed EAFE index closed down 7.60%, pushing it slightly into the red YTD. And the MSCI Emerging Markets Index was down 9.2%, leaving it in the red 12.85% YTD.

United States Government bonds were little changed, keeping the yield on the benchmark’s 10-year Treasury note at 2.22%. The 30-year U.S. Treasury Bond closed at 2.96%. Crude prices settled at $45.22 per barrel after climbing 10.3% on August 27, the biggest one-day jump for US oil since March 2009. Gold moved higher to close at 1,133.40.

Even those investing for the long-term can be unnerved by rapid, punishing declines in unsettled markets. Yet investors who panicked and sold when stocks took a nosedive in August surely regretted that decision only a day later. And there were plenty of folks who hit the panic button. As reported in the Financial Times, $19 billion was pulled from equity mutual funds on August 25, the second biggest day of redemptions since 2007.

Engaging in market timing during periods of turbulence may alleviate stress in the present moment, but locks in unknown future losses. Since the early 1960s, the S&P 500 has annualized 6.5% per year. But if you missed the five best days in the market during that period, the gain was pared to 5.6% per year. With compounding, this is the difference between seeing $100K grow to $1.7M versus $1.2M.

 

Historically, the market’s best days often follow on the heels of their worst, August being a case in point. Three of the worst days in stock market history were Black Monday in 1987, the 1929 crash, and the failure of Lehman Brothers in 2008. The market’s best days also occurred during the Great Depression, after the fall of Lehman, and in 1987.

For us humans, uncertainty is difficult. We like a clear sense of direction. Many factors can change the market’s direction for better or worse, and known data has already been factored into prices. Keep in mind that while the world economy is slowing, it’s not in crisis. Don’t let fear or uncertainty lead you to poor decisions. Had you been ruled by fear in 2010 and 2011 you would have missed quite an amazing run. That said, let’s address some of what’s on your mind.

Lately there has been chatter in the financial press about whether stocks are overvalued. Based on a valuation principle made popular by economist Robert Schiller, many investors believe there may be a way to predict when to buy or sell securities.

According to Schiller’s Cyclically Adjusted Price Earnings ratio (CAPE), equities are currently trading at 25 times trailing 10-year average earnings, while the average since the 1800s has been 17 times trailing 10-year average earnings. If Schiller's measure were to revert to its mean, the S&P 500 should be closer to 1600 than 1900, implying the risk of a further 16% fall from recent lows.

In financial markets “mean reversion” is the idea that higher than average returns will be followed by lower than average returns and vice versa. So if investors could anticipate when unusually high or low returns will end, they could sell or buy securities at advantageous times and earn higher returns.

This sounds fairly straightforward, and the existence of mean reversion cannot be ruled out. However, there simply is not enough academic evidence showing that it enables profitable predictive trading strategies, whether applying Schiller’s criteria or something else.

Lackluster Chinese manufacturing data and a subsequent 3% currency devaluation fueled concerns about the impact of China’s slowdown on the global economy. But whether this is or good or bad news for the world’s economy remains to be seen. Investors who were happy to hold shares a month ago should have been delighted to buy more after prices fell, as there have been no substantial changes. China looked shaky then, and looks shaky now.

Last week it was confirmed that the US economy grew at a 3.7% annual rate in the second quarter, much better than the 2.3% rate initially reported. The Federal Reserve may raise rates, but the market volatility has given policy makers an excuse to keep rate hikes on hold. We cannot know when interest rates will rise.

Bottom line: No one can predict whether the market’s next sustained move is up, down or sideways. So the best strategy is to ignore the dips, focus on the long-term, match your asset allocation to your risk tolerance and investment objectives, remain patient and have realistic return expectations.

If concern about your investments is keeping you awake, let’s talk. Increasing your allocation to bonds is always an option. But with bond yields dismal and cash yields virtually zero, equities are still likely to yield more than the alternative for investors with a 5, 10, 15 or 20 year horizon.