The recent bout of financial market volatility has raised a key question – is this just a bump in the road or the start of a bear market?
Global markets have been roiled by the weakening economic outlook in China. The ripples have extended far beyond Asia as other emerging markets have suffered and commodities sold-off hard.
Increasing anxiety over the strength of global economic activity has been exacerbated by the uncertainty regarding Federal Reserve monetary policy. The decision whether to raise rates has led to greater confusion and ambiguity.
Yet the economic fundamentals here in the U.S. remain strong and there are reasons to think that the U.S. economy will continue to improve.
This month’s newsletter looks at whether the recent market movements are transitory or something more persistent. Is this a bump in the road or a bear awakening?
In August, the benchmark S&P 500 index fell more than 12 percent from its recent peak, which it hit back in May. Last month’s Gibraltar View covered the reasons for the recent declines in equity markets and the context of the first stock market correction in more than three years.
The rally we have seen in recent weeks, and the very strong start to October, suggest a rebound is under way. It could be just a short-term bounce –a so-called “dead cat bounce”, but the large-cap index is now back in the black for the year so far. Nevertheless, there is sufficient uncertainty in international markets, especially China, to spark further investor unease going forward.
As we enter the final quarter of 2015, many investors are starting to question in which direction the next move in equity markets will occur.
As per the chart to the left, stocks have been oscillating in a narrow upward trend since the start of last year. Yet, the sell-off in August has raised the question of whether this is the start of a bear market or just a bump in the road.
In the September newsletter, we concluded that a correction is something we have been anticipating for a number of months. Indeed, the anomaly is not that equity markets declined from the recent peak by more than 10 percent, it is that this has not occurred sooner. Far from being something to worry about in itself, it is much more likely to be a return to regular market functioning and volatility.
For the past few years the volatility of the S&P 500 equity benchmark index has been notably below typical historic averages. As one can see from the chart below, the recent standard deviation of returns for the S&P 500 has been significantly less for the last three and five years as compared to the longer timeframes.
Let’s Get Technical
The recent volatility in equity markets has produced a raft of opinions and provoked many different reactions. It is not unreasonable to find that many of the reactions have been emotional – investors still remember the distress of 2008/9. It is also undeniable that the unedifying need to fill column inches, online clicks and financial TV shows that appeal to as many people as possible, often resort to hyperbole above fact.
It has been notable that a number of technical market analysts have been very active in the last few weeks. Technical market analysts look at a number of quantitative data trends to discern a potential shift in the direction of markets.
Technical analysis relies heavily on moving averages and evidence of historical patterns being replicated.
Many technical studies of late have focused on potential likelihood of moves lower in equity markets. Much of the recent work has looked at the key levels, which the major indexes could hit.
As per the chart above, these levels are considerably lower than where the benchmark index is currently. Analysts have noted that the recent decline matched the bottom of the sell-off reached last October, right around the 1,860 level. Furthermore, some analysts have suggested that if additional declines occur then the market could test the 2014 low of 1,750. These markers, in red on the chart above, are called “support” levels where the market could either bounce back higher, or if it falls through that level, it would be a signal that the market would fall further still.
Technical analysis can be useful to discern short-term dynamics within the markets and especially the strength and momentum of buying and selling. But there are limits to the predictive power of charts and patterns that is not necessarily relevant over longer-term investing horizons.
At times like these, it is often wise to take a step back and take a more considered view of events. The chart on the following page shows the long-term trends in equity markets. It signals the aggregate gains and losses from the past five bull and bear markets.
The truth is that we see large and persistent market moves over many years and U.S. equity market benchmarks have appreciated strongly from the lows hit in March of 2009.
The recent volatility we have witnessed is far more typical than investors have become used to in the past three or four years. It is also not unusual to see intermittent bouts of volatility within longer duration bull markets.
What has Changed?
The recent disruption across global equity and commodity markets has intensified concerns regarding China and the global economic outlook. Yet, it is worth looking beyond the market volatility to discern what exactly, if anything, has really changed in the past few months.
The truth is that for the U.S. the economic data has, on balance, remained solid. There have been areas of relative weakness, but there are good, logical reasons for that and the preponderance of the data continues to be robust.
For example, the last two Department of Labor jobs reports have shown a slowdown in the pace of job creation. However, the below-expectations number of new jobs should not be over-interpreted as unequivocally bad news.
Summer jobs reports are often misleading and are frequently revised in subsequent months. Moreover, a slowdown should not be unexpected given the robust pace of job creation and the fall in the unemployment rate that has happened over the last few years. Indeed, other data from the job market, such as initial claims for unemployment benefits suggest that conditions in the labor market are continuing to improve.
The housing data also remains positive. The rebound in average home price has slowed in many areas across the nation. But this means the pace of
price gains has decelerated – it is still rising, just not as fast. This could actually be a good thing given the real estate exuberance which was a base
cause of many of the problems underlying the financial crisis in 2008!
Taken together, the enduring improvement in jobs and housing means that U.S. households are in good shape. As a result, the most important component of the U.S. economy, consumption, is robust. Domestic consumption accounts for roughly 70 percent of U.S. gross domestic product (GDP) and is the most vital factor driving economic activity. We have seen robust retail sales data, although last month’s data was below forecasts. Auto sales especially have been impressive and consumer sentiment remains strongly positive.
While we are generally cautiously optimistic, the data has not been totally positive. For example, the U.S. manufacturing sector has been struggling for a number of months.
Many industrial firms are struggling to cope with the appreciation of the U.S. dollar, which has resulted in U.S. manufactured goods being relatively more expensive on world markets. This is easily observed in the chart above. As the dollar started to appreciate back in June of last year, there has been a steady erosion in the strength of the manufacturing index.
The strengthening of the dollar has also had an impact on corporate earnings. We are currently in the midst of third-quarter reporting season and there are broad expectations for a modest decline in profits, largely due to the currency appreciation. A larger than anticipated deterioration is something that we are watching closely, but it is notable that profit margins are at all-time highs and balance sheets are strong.
Furthermore, there are still plenty of issues impacting the global economic outlook and a general overhang of uncertainty. It is unlikely that we will see sufficient catalysts for significant equity market gains until the outlook in China looks rosier and there is more certainty regarding the path of monetary policy. The Federal Reserve exacerbated market uncertainty following the September policy committee meeting, but the fact that rates will be lower for longer is positive for stocks.
There are sufficient signs of durability and domestic economic strength to believe that we are not at a long-term inflection point for equity markets. The bear may be stirring but has not awoken yet!
We remain marginally overweight U.S. equities, neutral-weight international and underweight emerging markets. The appreciation of the dollar had created headwinds for developing economies and commodities that could yet persist, especially if the Fed moves to raise rates in December.
We modestly cut bond allocations in portfolios last year, in anticipation of yields rising, and we are comfortable remaining underweight high-quality bonds and shorter than benchmark duration for now. We maintain that an upside bias to rates will prevail over the next year as markets anticipate Fed rate increases.
We still favor flexible mandate credit strategies and believe that municipal bonds and mortgage-backed securities remain relatively attractive.
We continue to see value in maintaining allocations to alternative strategies, especially macro and quantitative futures managers, in order to diversify risk as we expect continuing volatility across all asset markets for the last few months of 2015.
If you would like more information, please contact your Wealth Advisor or contact us at 305.476.1982.
Jonathan Hill, Director of Investments
Disclaimer: This information is not meant as a guide to investing, or as a source of specific investment recommendations, and Gibraltar Private Bank & Trust makes no implied or express recommendations concerning the manner in which any client’s accounts should or would be handled, as appropriate investment decisions depend upon the client’s investment objectives. The information is general in nature and is not intended to be, and should not be construed as, legal or tax advice. In addition, the information is subject to change and, although based upon information that Gibraltar Private Bank & Trust considers reliable, is not guaranteed as to accuracy or completeness. Gibraltar Private Bank & Trust makes no warranties with regard to the information or results obtained by its use and disclaims any liability arising out of your use of, or reliance on, the information.
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