The third quarter of 2015 may be remembered as the time when investment market volatility returned with a vengeance. The US Federal Open Market Committee, the branch of the Federal Reserve Board that determines the direction of economic policy, compounded the issue by adding even more uncertainty to an already murky interest rate policy. The quarter began quietly enough with the S&P 500, an index used to track the US stock market, trading between 2,050 – 2,125 (which had been the trading level since mid-March). Then we reached mid-August.
On August 11, The Peoples Bank of China (PBOC), China’s central bank, devalued the Yuan (China’s currency) to the lowest rate within the past two decades. The last major currency move made by the PBOC occurred in 2005. Prior to 2005, the Yuan was had been pegged at 8.28 to one US Dollar (USD) for a decade. In 2005 the PBOC moved from a pegged rate to a self-described “managed floating exchange rate regime.” Essentially they let the currency float in a 2% range around a “reference rate.” That reference rate is announced to the market at 9:15 am in Shanghai each day. This exchange rate method contrasts with a free-floating currency like the British Pound or Euro. The value of those currencies are determined entirely by supply and demand. Since the value of China’s currency is not as subject to the fluctuations caused by supply and demand, the PBOC is able to indirectly determine the cost of goods exported. For example, reducing the Yuan’s value could actually spur economic growth by making exports more attractive. The more Yuan you can buy with one USD, the cheaper the goods (relatively speaking). This brings us to the August 11th move. The PBOC reduced the reference rate by 2% with no prior warning. This unannounced shift spooked investors who read it as a signal that China’s economy was slowing at a greater rate than previously assumed.
The Chinese maneuver set in motion a market sell-off which saw the S&P 500 drop 12% between August 17 and August 25. At the same time the volatility index (VIX) went from a boring 12.83 to a roaring 40.7. The US Federal Open Market Committee added fuel to the fire when it failed to raise interest rates during its September meeting. The Committee’s September statement was the first to acknowledge that outside factors (i.e. China) could play an increasing role in the domestic economy, potentially causing further slowdown. Janet Yellen, the Chair of the Federal Reserve, quickly took to the airwaves to calm nerves and reiterated the target of raising interest rates this year.
What does this all mean? Stock market corrections (usually defined as a 10% drop in the market, a definition that the current market meets) are hard to understand. Often they happen in the midst of long-term bull markets. But why? Is it like getting the flu? Is it just emotion? Or, are corrections necessary to purge the excess optimism of investors? Our answer: we don’t really know. One thing we do know is that almost every time market corrections happen, pessimists come out of the woodwork saying that a bear market (a 20% or greater market drop) has begun. In the past seven years’ corrections have happened a number of times, but each time, the market has bounced back to new highs. Think about 2011, when the S&P 500 fell by 19.4% from April 29th to October 3rd. Even with the recent decline, the S&P 500 is up 77.5% since then. We are not saying a bear market isn’t possible. Indeed, they do happen. The S&P 500 has lost at least 20% of its value 12 times in the last 70 years (on average once every six years). It has been seven years since the last bear market began. History would indicate that we are overdue.
Despite the market’s recent behavior, we still see plenty of positives in the current environment:
- The outlook for the U.S. housing market continues to brighten.Inflation remains tame–the fall in commodity prices will keep inflation below the Federal Reserve’s target.
- Lower oil prices bode well for the U.S. consumer.
- U.S. price-earnings multiples have fallen; stocks are fairly valued in our view.
- Europe appears to have weathered the latest Greek crisis.
- European economies are showing some positive signs.
It is not possible to foresee every crisis or every developing bit of positive economic news, nor is it possible to predict how markets will react to these events. However, investors have a certain level of control over their investment destiny, despite short-term market movements. By setting goals and properly aligning resources with those goals, market events become little more than noise. Market volatility, corrections, and bear markets often make investors feel like they have to “do something.” While it can be unnerving to watch portfolio values decline, market volatility alone is not a good reason to make changes in a properly constructed portfolio. If declining markets have you worried, instead of buying and selling investments in hopes of minimizing damage to your portfolio, it might be time to reassess whether or not your investment philosophy is in alignment with your goals. Perhaps your time horizon is shorter than you originally thought, or maybe you need to hold a larger cash position. It is important to discuss your concerns with your advisor. As always, we will discuss these issues with you during our next review.
The views and opinions expressed are of White Horse Advisors, LLC. This commentary is provided for educational purposes only and should not be construed as investment advice. White Horse Advisors is an investment advisor firm located in Atlanta, GA.