Market & Economic Overview: Third Quarter 2015
Increasing concern about China’s economy, accompanied by a modest (but unexpected) devaluation of their currency, led to a sharp drop in global equity markets in late August, with the S&P 500 Index falling 12% from its high reached just a month earlier. This marked the first 10%-plus correction for the U.S. market since 2011, an unusually long stretch given historically a correction occurs about once a year. The S&P 500 has experienced a 10%-plus correction 52 times since the end of World War II, so these corrections are not unusual. Investors must be prepared to experience such drops repeatedly over their investment lifetime.
Given the market’s historical pattern of corrections, we’ve been expecting one for some time, so we weren’t surprised it happened. But we weren’t predicting one; short-term market predictions are a guessing game, and one we don’t participate in. But knowledge of market history is useful for putting the current market into context and thinking through different potential risks and investment opportunities.
For the third quarter the S&P 500 ended down 6.4%. This marks the first negative quarterly return for the index since 2012; again, an unusually long span. This August and September marked just the 12th time since 1959 that the S&P 500 was down in both months. Following such drops, the fourth quarter return was positive in all but one year (1977), with a median gain of 7.9% (source: BTIG Research). History does not repeat, but it often rhymes.
Developed international stocks, as measured by the MSCI Eafe Index, were down 10.2%. Emerging-markets stocks fared the worst, dropping over 20% from their high in early July to their low on August 24. For the quarter, the MSCI EM Index was down 17.9%. That return includes several percentage points of losses to dollar-based investors from the continued depreciation of emerging-markets currencies. Given the negative environment for global stocks and disappointing developments in China, it’s not surprising emerging-markets stocks had poor performance. But based on their relatively cheap valuations, we view EM stocks as attractive over a five-year investment horizon. We also recognize they are riskier than developed market equities and therefore represent a relatively small allocation in portfolios.
Since 1950 the S&P 500 has suffered a 20%-plus decline nine times — the common definition of a bear market. So on average, bear markets have historically occurred about once every five years. The current bull market now stands at over six years. The longest stretch without a 20%-plus decline was the 12-plus years ending with the bursting of the tech stock bubble in 2000. So while the bull market is getting long compared to average, the old saw on Wall Street is that bull markets don’t die of old age, they die of over-valuation and rampant speculation. While markets appear full to slightly-overvalued, we don’t see many signs of froth. On the contrary, 75% of investment advisors and newsletter-writers polled by Investors Intelligence were recently bearish. The last time that occurred was in March 2009 (the market low).
Lost in all the volatility of the markets during the quarter was some good news: Second quarter GDP growth was revised up to a rate of 3.9%, and corporate profits increased 3.5%, after a slump in the first quarter. Single-family housing starts are growing at almost 20% year over year, auto sales are very strong, and employment continues to expand (see charts “Employment – Total private payroll”).
Most indicators point to a consumer who is finally starting to spend some of the savings from low oil prices (consumer spending drives two-thirds of the American economy). The next bear market will likely start due to a recession, not contagion from China or elsewhere. Currently, there is little indication in the U.S. that a recession is on the horizon.
The Federal Reserve
We do not make our long-term capital allocation decisions based on speculation about what the Fed will do. First of all, we don’t have an edge (and neither does anyone else, in our opinion) over the market in making that type of prediction. Even the Fed itself, in all its noble efforts at transparency, can’t seem to come to an agreement. Second, and more relevant in the current environment, no one really believes that moving the Fed Funds rate from 0% to 0.25% is going to have any real implication for the global economy. However, once they do move, the pace and magnitude of subsequent hikes could make a difference. After all the hand wringing and volatility in the markets leading up to the September meeting, the Fed did…nothing. At the end of the day, it seems like they view the risk of raising early as bigger than the risk of doing so too late, because inflation is still lower than their target level. Publicly they say it will happen late this year, but the markets are currently pricing in less than a 50% probability. Again, while we don’t engage in Fed speculation, our view continues to be that the sooner they get on with it, the better for us all.
While not invested directly in oil, we feel compelled to comment, as the significant decline from over $100 per barrel to the current price of around $50 has likely had an impact on market volatility. We view the decline as a net positive, at least for the U.S., Europe and other oil importers. While some of the weakness is attributable to the slowdown in China, we think the bigger issue may be the increased supply coming from the U.S., via new and cheaper extraction technologies. What’s interesting is that Saudi Arabia has not acted to cut production to support prices, as they have in the past. According to the International Monetary Fund, the Saudis have had to withdraw $50 – $70 billion from global asset managers to meet their fiscal needs during this slowdown. This may have contributed further to the equity market pullback this summer.
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