Market Selloff – Keep Calm and Carry On?

Global financial markets are under pressure. As we write this, US stock indices have retreated approximately 11% from highs reached this spring and summer. Foreign benchmarks are down more, led by China. Explanatory factors can be categorized as economic or market-related – we address those below.

While no two situations are the same, history provides critical perspective. Long periods of rising share prices are regularly interrupted by corrections such as the one currently unfolding. In fact, it had been four years since we had seen a 10% or larger decline. The onset of corrections can be stressful. Trying to anticipate these events is a losing proposition, but being prepared for them is a necessity.

Before getting to China, the most widely cited catalyst for the downturn, we’d like to describe recent market behavior and how it has contributed to the sudden drop for US stocks. Until last week, the year’s best performing stock selection approaches have been those based on momentum. At the beginning of each new month/quarter/year, one invests in whatever has gone up the most over the previous time period. In a year where overall corporate profits are expected to grow slowly, if at all, investors have been attracted to companies not struggling with lower oil prices or a stronger dollar, such as biotech firms or online retailers, until recently showing gains of 30% or more in 2015. The performance of indexes such as the S&P 500 has been impacted by the action in a handful of larger stocks (Amazon, Facebook, Netflix, etc). Of the last twenty-five years, there have been only two like this one where momentum strategies have worked so well (1993 and 2007). We have been surprised to observe some institutional investors jump on the momentum bandwagon.

The strategy stops working when the number of “believers” begins to decline. What triggers the change can be a few negative earnings reports or an unexpected outside event (such as a surprise currency adjustment for the world’s second-largest economy), but that matters little to the adherents. Momentum stocks can be crushed in the aftermath, because they generally would not appeal to conventional growth or value-focused investors until their prices reset much lower. But the adjustment process can be messy for all stocks, as index and ETF investors are unsettled by rapid price changes (as witnessed yesterday). The transition away from such an unsustainable strategy should be greeted with relief, because markets and economies mutually benefit from stability and realistic expectations. We’re confident we’ll get there, even if we can’t say when.

Here’s some background on China: their problems are worse than ours. Economic growth is slowing, the population is aging quickly and there’s too much debt in the wrong places. The Chinese response to the 2008 credit crisis was to create even more production capacity, expecting exports would grow back to previous levels. It didn’t happen. With the Chinese currency pegged to a dollar that has been strengthening versus the euro and most other currencies, Chinese export prices have been falling in order to remain competitive. On August 11th, the Chinese central bank announced a currency devaluation. It won’t change the fact that the world doesn’t need more of what China wants to sell. The government still has deep pockets and appears to have room to ease fiscal and monetary policy; we don’t know how quickly and how effectively it will respond. We must consider the possibility that past mistakes could be repeated (building unneeded cities, buying overvalued stocks). While this is likely the beginning of the end of China’s rapid growth, we’re skeptical it’s all ending with a bang right now.

These types of market moves often test people’s patience and discipline. Memories of the last major correction quickly return. It is easy to say ‘keep calm and carry on’ but sticking to it is more difficult. It will take time to define a new trading range for stocks. We do not see the ingredients for a prolonged US recession, nor do we foresee a crash like 2008. One difference that matters is the health of the US financial sector, which has significantly de-risked and replenished its capital.

The success of a sound investing strategy does not rely on momentum, nor does it require forecasting near-term economic developments. If you’re feeling uneasy, or in/near retirement, we strongly advocate using this opportunity to evaluate your overall risk profile. In our opinion, the best way to do this is through financial planning and modeling different outcomes based on alternative investment results.