Thoughts on Recent Market Volatility

Market VolatilityWhen global equity markets enter periods of elevated volatility like we’ve experienced recently, it’s wise to take a breath and gain some perspective. If equity markets were perfectly rational and priced new information efficiently, we would not see such periods of heightened volatility. In reality, equity markets can be quite inefficient and irrational over short-term time horizons as stock price volatility exacerbates intrinsic business value volatility. As investors, we focus more on intrinsic business value volatility, which is the present value of cash that a business is expected to generate in the future. Although market participants emphasize company earnings over the next quarter or year, we estimate that a years’ worth of company earnings represent about 5-7% of a company’s intrinsic business value. Short-term equity market volatility and inefficiencies exist because investors over-react to news that has little correlation to long-term intrinsic business value.

This reality validates our opinion that many market participants don’t care about intrinsic business value, all they care about is momentum. If earnings momentum is rising, investors will bid up prices well beyond their intrinsic business value so long as the tide of earnings momentum remains in place. Likewise, when earnings momentum is declining, investors will sell stocks well below their intrinsic business value. In short, when equity markets are performing well, risks are unappreciated and when equity markets are performing poorly, opportunities are unappreciated. This dynamic exists because investors tend to extrapolate recent events too far into the future, while discounting the potential for change. Wise investors approach the market with a sense of humility and respect for the possibility of change and mean reversion. This is why value investing with a margin of safety is so important because it acknowledges that the future is uncertain and provides a layer of principal protection in the event of an adverse outcome.

With that in mind, it’s important to remember that prior to the volatility of the past few days, the U.S. equity markets have been in the 3rd longest stretch of gains without a double digit correction in the last fifty years. In fact, the last time the U.S. equity markets experienced a normal 10% correction was in the summer of 2011. Recent volatility inevitably produces flashbacks to 2008, but clients should know that we are in a much different and stronger environment than 2008 and equity markets were simply overdue for a correction. This is a normal occurrence that investors should expect from time to time in the equity markets. A good financial plan incorporates periodic market corrections into its projections, so in most cases, the proper response for clients is to stay the course. If you haven’t done a financial plan, I’d encourage you to consider the benefits of planning. Comprehensive financial planning helps clients think about the big picture, which is something that’s easy to lose sight of in the midst of short-term volatility.

The trigger for the recent market correction can be attributed to 3 things: 1) Slowing growth in China and currency devaluation, 2) Oil prices hitting 6 year lows, & 3) Uncertainty over increase in interest rates. My opinion is that the market reaction to China’s currency devaluation was overblown, given the fact that China represents about 2% of S&P 500 revenues and less than 1% of U.S. exports1 & 2. Outside of the technology sector (10% of sales from China) and basic materials sector (2% of sales from China), the direct impact of China on most sectors in the S&P 500 is negligible1. China’s primary impact on the global economy centers around commodities, since they consume an eighth of the world’s oil, a quarter of its gold, a third of its cotton, and about half of the major industrial metals according to a recent Wall Street Journal report3. China’s recent move to devalue their currency by 2% is a tool they are using to help support exports, which comprise roughly 30% of their economy. Reducing interest rates, reducing bank reserve requirements, and reducing the value of the Yuan currency indicates policymakers in China are both worried about economic slowdown and resolved to revive its growth.

In regards to oil, most people ask the question: “How low will oil prices go?” We think the more appropriate question is, “What oil price brings supply and demand back into balance?” I’m not sure what that answer is but I’ll bet it’s not around $40 per barrel, where oil prices trade today. The price declines in many of the oil and gas exploration and production companies have reached a magnitude I’ve not seen since the financial crisis of 2008. Investors are extrapolating current oil prices into the future and not placing fair value on the replacement value of their proved reserves, which will likely be developed in future years when oil prices are trading at much different levels than they are today. Whenever supply and demand do begin to get back into balance, energy stocks should rebound as well. Until we get to that point, however, low oil prices will give a nice boost to consumer pocket books as consumer spending represents 70% of the U.S. economy.

Finally, in regards to investor uncertainty over interest rate increases, we believe the economic fundamentals are strong enough in the U.S. to justify raising interest rates. Over the past 4 recent quarters, the U.S. economy has grown year-over-year by 2.9%, 2.5%, 2.9% & 2.7%. 0% interest rate policy is not needed and market participants should not panic about the economic impact of a modest upward movement in interest rates. But that doesn’t mean the market won’t react. Since all asset prices are tied to interest rates, it would not be a surprise to see further equity market volatility when interest rates are raised. We have been saying for a while now that stock prices have gotten ahead of fundamentals and eventually they will need to enter a period when that gap narrows. Perhaps this correction is the beginning of that period in the equity markets.

1—http://www.bloomberg.com/news/articles/2015-08-10/here-are-the-s-p-500-stockswith-the-highest-exposure-to-china
2—The US-China Business Council Annual Report. https://www.uschina.org/reports/usexports/national
3–http://www.wsj.com/articles/china-remains-a-key-commodities-player-despitewaningappetites-1440534872
The S&P 500 consists of 500 stocks chosen for market size, liquidity and industry group representation. Each stock’s weight in the index is proportionate to its market value. The S&P 500 is one of the most widely used benchmarks of US equity performance.

The opinions and forecasts expressed may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. The advisor does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions. Past performance does not guarantee future results.

Diversification can be thought of as spreading your investment dollars into various asset classes to add balance to your portfolio. Although it doesn’t guarantee a profit, it may be able to reduce the volatility of your portfolio.

Photo courtesty of CoolDesign from FreeDigitalPhotos.net