As of the market close yesterday, 8/25/15, the S&P 500 has declined -10.9% since the drawdown began last Tuesday, 8/18/15. (See Chart 1) This is the largest drawdown since August 2011, so while disconcerting it is far from unprecedented. (See Chart 2) It is our belief that the magnitude of the sell-off was made worse by the fact that August is a vacation month, which means that liquidity is lower than usual. As a result, stock prices had to decline sharply to draw in enough buyers to accommodate all those that wanted out.
The big question is, why did the sellers want out so badly? The biggest reason for the sell-off appears to be China. The Chinese economy is slowing at what seems to be a rapid pace (it is impossible to know by how much exactly). There is a lot of concern about the impact of the slowdown on both the stocks of companies who export to China and the currencies of countries that trade with China – which is nearly every country. There is a growing sense that conditions are worse than previously suggested. The People’s Bank of China has taken steps to improve the economy, including cutting interest rates and lowering the value of its currency relative to other world currencies. Of course, every new initiative that a command economy takes in a crisis reinforces the notion that the government is not in control, which risks further loss of confidence.
That said, we do not look at the current market sell-off as the beginning of a 2008-style meltdown. The financial system today is in much better shape. The biggest differentiator between today and 2008 is the fact that the financial sector is much better capitalized. This situation may play out more similar to 1987, 1998, or 2011, wherein economic/political difficulties in one important nation led to dramatic changes in currency values across the globe. The instability and uncertainty caused a sharp market reaction and a temporary slowdown in business activity, none of which led to a recession or prolonged drawdown in the United States.
There are very sophisticated algorithmic programs that can detect greed and fear that we believe are contributing meaningfully to current volatility. When they were helping to push stocks up during the bull market of the last four years, calls to restrict their activity mostly fell on deaf ears. Now that we see high frequency trading contribute to sharp market declines, opinions on regulating their activities are likely to change.
Looking forward, there is not much for the short term investor (is speculator a better word?) to be optimistic about. Momentum is clearly to the down side, technical support has been shattered, and investor psychology is poor. The long term investor, on the other hand, should see an economy still growing modestly and stocks trading at their cheapest level since October 15th and 16th of 2014 (though even at these levels stocks are not cheap on a historical basis).
If this is a steep correction in an ongoing bull market, previous leadership (growth stocks in the health care, consumer product, and information technology areas) will re-assert their place at the top of the performance lists. If we are going into a bear market, then because these sectors rose the most it is likely that they will fall the most. Eventually new leadership will emerge. Yesterday health care was again a leading sector, and momentum stocks like Facebook and Netflix outperformed the average stock, so we have to assume for now the correction scenario is more likely.
Some further thoughts:
- Technically the U.S. stock market can no longer be considered to be in a bull phase. As long as this is the case, investors will have a tendency to sell strength (as opposed to buying on weakness).
- Stocks tend to be supported either by a prevailing upward trend or the notion that they are cheap. In either case, obviously, time is on your side. In the absence of either, which is where we are now, it is hard to sustain a rally.
- It cannot be assumed that if stocks continue to decline that high quality bonds will rally. That usually happens but has not happened this week because there is still the belief that the Federal Reserve will raise rates, and that in any event rates are too low. Gold is not a reliable stock market hedge either.
- I would feel better about our ultimately being much closer to the end of the correction than the beginning if transportation stocks were doing better. The decline of transports in the face of significantly lower fuel costs (which should be a positive) is a concern as to the real health of the economy.
- I would expect the domestic focus and the yield of REITs and utility stocks to make them attractive to investors (on a relative basis) in this environment, but this has not happened yet.