Last week, stock markets fell globally in the toughest week of 2015 to date. Investors weighed concerns over China, the potential for interest rates to rise in the U.S., and rocky emerging markets. Below, read more about what we think matters most to investors—and how they might respond.
As of market close on August 21, 2015, the S&P 500 Index declined 6.9% from its late-May peak, while most other global equity indexes have experienced steeper losses from their respective 2015 highs. For instance, U.S. small cap stocks (Russell 2000 Index) have dropped 10.3% since late-June, while equity markets outside the U.S. have also fallen significantly from their earlier-year peaks. Emerging-markets equities (MSCI EM Index) have been particularly hard-hit, dropping 22.8% since late-April, while non- U.S. developed equities (MSCI EAFE Index) have lost 8.9% since late-May. Meanwhile, oil prices have continued to plunge in recent months, and commodities markets (Bloomberg Commodity Index) have experienced a 16.4% pullback since mid-May.
Given the elevated levels of volatility and turmoil in the markets, we think it’s a good time to address a few key topics and summarize our views.
Why did this happen?
In short, China. The broad U.S. equity market, which reached record-topping levels in early spring and summer, suddenly plummeted on August 17, with the rout continuing ever since. Fears that world’s second largest economy is slowing dramatically appear to be behind the sell-off. Beijing’s unexpected decision to devalue its currency on August 11 first raised red flags; weak economic data in the weeks following have further raised alarm.
As seen this past week, China’s global importance means any disruption to its economy reverberates around the world.
Does this mean we’re entering a correction?
A correction is typically defined as a decline of at least 10% in a stock, bond, commodity, or index. Generally, it is a temporary price decline within a bull market, but it can be a precursor to a bear market. The Dow Jones Industrial already suffered a 10% plus decline. The Index peaked at 18,312.39 and closed on Friday at 16,459.75 (a 10.12% decline). The Dow also opened sharply lower on Monday. So, yes, it does appear that we’ve entered correction territory.
Are stocks still overvalued?
The bull market had been getting long in the tooth, and overall valuations were looking rich. As of Friday, August 21, the S&P 500 had rallied for 1,418 days without a 10% correction, the third longest rally since the index’s inception in 1957. As of this morning, the streak looks to be in jeopardy with this morning’s price (1928) down nearly 10% from its peak of 2130.82 on May 21, 2015.
In our view, the overall market appears closer to fairly valued as of this morning. History tells us the price of the market can swing sharply in both directions, from overvalued to undervalued–especially over shorter time frames.
One valuation measure we like to monitor is the Shiller P/E ratio, which compares the S&P 500’s price to its 10-year average of inflation-adjusted earnings. As of March 31, 2015, this measure stood at 27.1. This morning the ratio is down to 24.1, which is right near the average over the past 25 years and modestly above its average of 19 since 1970. Another measure of overall market valuation is the S&P 500’s trailing price-to-earnings ratio, which stands at 16.9 as of this morning versus a long-term average of 16.4 (going back to 1954).
While it’s natural to focus on the stock market’s daily price action, especially in periods with greater volatility like today, we think investors can’t afford to get caught up in emotion, or lose sight of their overall longer investment time horizon, even when the ride gets bumpy as it has been over the past week.
What about the price of oil?
U.S. crude oil prices dropped below $40 per barrel in early-morning trading on August 24, down more than 50% from a year ago. The first leg down in oil prices was caused by increased supply and Saudi Arabia’s decision in late 2014 to let prices fall further by increasing production instead of trying to prop up prices by cutting back. A few factors have contributed to the near-term fall in oil prices, which started in mid-July 2015. Data showed oil production has remained fairly high despite the new low-price environment and the Iran nuclear deal could lead to additional supply. The most recent negative surrounds the potential for weaker demand due to further slowing of China’s economy. China is the world’s second largest consumer of oil, behind the U.S., and has been a key source of increased demand for oil in recent years. That said, lack of demand does not appear to be oil’s main problem. In August, the International Energy Agency raised its 2015 forecast for global oil demand to growth of 1.6 million barrels per day for the year, with additional demand growth projected for 2016.
Should investors worry about the prospect of rates rising quickly?
Yes and no. In the near term, we’re not overly concerned about rates rising quickly. It’s true that the Federal Reserve has been inching toward a rate hike, with the market recently forecasting a 50/50 chance of a move higher in September. But the Fed’s primary impact is on the very short end of the yield curve through the federal funds rate. Longer-term rates are largely determined by market forces, and the most recent move down in commodity prices is likely to further dampen inflation fears. As a result, longer-term rates have moved lower, not higher. That said, our longer-term forecast is that investors should account for the possibility of higher rates in the future. Global rates remain near historic lows and the global economy has been slowly getting back on its feet. Investors aren’t getting paid much to take on a lot of interest-rate risk.
What do you expect to happen next?
The future is always uncertain, and markets will always go through periods of high volatility. In the past five years, U.S. stocks have marched steadily higher despite a number of events that have threatened the rally. Several rounds of the euro crisis and the Greek debt crisis, the 2011 debt-ceiling crisis and debt downgrade in the U.S., the 2014 Ebola scare, and Russia’s annexation of Crimea, are just a few events that have rippled through markets. And the 2008-2009 global financial crisis remains a painful reminder of what can happen in a worst-case scenario. But we think investors are best served sticking to their long-term plan and not giving in to the twin vices of fear and greed.