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Equity Markets and Summer Volatility

Last August/September the S&P 500 fell 11%. It recovered its losses by early November. For the first six weeks of 2016, the market dropped 12%, and then climbed back to even by mid-March.  But between October 2007 and March of 2009, the S&P 500 fell over 50% and did not see new highs until March of 2013. And lest we forget, the highs of the tech bubble on March 20, 2000 were not reached again on the S&P 500 until May of 2007.

How do you know when a decline in the markets will stick long enough to be a genuine bear market (stocks down at least 20% and a full recovery taking longer than one year) or when you are only witnessing normal volatility? In the former case, you may want to pull back on some risk exposure, while in the latter case riding out the turmoil may be a better choice.

Most sustained bear markets coincide with recessions. That was the case in both the 2000-2002 bear market and again during the more recent financial crisis.  Only one true bear market in the last 35 years (1987) avoided a parallel recession. I wrote a blog last February providing our 2016 outlook for a recession and concluded  that, at least in the near term, a recession was not on the horizon. I maintain that view.

I also wrote a blog back in November 2015 entitled “When to be Nervous and When to be Calm” discussing the key factors (a recession, an asset bubble, a credit crisis and/or an exogenous shock) that can lead to sustained volatility. At issue is whether the causes of market volatility are tied to longer term, fundamental weaknesses in the economy. If they are, they can act like bear claws and tear the markets apart for a sustained period of time. If not, then markets will often suffer only short term fluctuations.

I tie short term volatility to “Events.” This particular type of event is a one-time or time-constrained occurrence, that can make investors extremely nervous, and by their very nature have an impact that is most often limited either in duration or severity.

The debt ceiling crisis back in August of 2011 is a perfect example. Markets panicked when the deadline for raising the debt ceiling became a political pawn and the Standard & Poor’s downgraded the US credit rating. At the time many investors believed that the Congress would not be so ill-advised as to truly allow the US to default, but the markets felt the need to riot to get the politicians’ attention. After losing 19%, markets snapped back a few months later.

The same can be said for the Fiscal Cliff and Sequestration, which were also short- lived political events that sparked selloffs. And Greece – remember Greece? Its threatened exit from the EU was never going to impact the US economy in a big way, but it still inspired market volatility on several occasions.

So what about today? Are our worries events or potential bear claws?

Markets are currently concerned about China, commodities, the Federal Reserve and politics. I would put commodities and politics in the pure events category.

Although I believe commodities (notably oil, gold and industrial metals) to be in a longer term secular bear market, the rockiness of the energy markets has been relatively short lived and limiting in terms of its overall negative impact on the economy. Oil prices have been stabilizing the last few months, as the supply/demand equation (a time-constrained event) has been correcting. If the drop in oil prices were going to send the US into a recession, it would likely have happened already.

As for politics, I tread very lightly here. But I notice that already the markets are trying to come to terms with a Trump candidacy, noting that presidential power is limited by both Congress and the judicial branch of government. Yes, any president has the capacity to trigger a major geopolitical response to  words or deeds. However, the markets are currently betting that it is not overly likely for any president to single handedly and dramatically impact the US economy or to start a major conflict without the advice of a much larger team of tempering consultants. This belief does not rule out short-term volatility based on uncertainty over policies a president might adopt.  But at the moment a sustained bear market derived from the election is not being factored into the market equation.

So that leaves us with China and the Federal Reserve.

China is hardly an event, although the stories about China – lack of control over its currency, mountains of debt and a potentially restless population — are themes often isolated into events. The key to China is what happens in the longer term. Chinese leaders have enough control, reserves and tools that they are unlikely to allow their economy to dive into recession in the immediate future (the proverbial hard landing). More likely, China will continue to handle a series of events with piecemeal strategies, as they struggle to put together longer term policies to improve and maintain the health of their economy. In other words, band aids in the short term but no gaping wounds from bear claws.

The Federal Reserve is also not an event, although each potential rate increase is treated as one. Here again we need to look longer term. There are legitimate concerns that the Fed will move too fast or too slowly in raising interest rates, thereby opening up the possibility of a recession in the future. But precisely because the Fed is moving extraordinarily slowly, there is little reason for markets to riot (except to make a short term point). Expectations are for rates to be lower for longer. These low rates combined with very accommodative global central bank policy create support for US Treasury prices, which in turn helps to keep a floor under stocks.

What we are left with is an economy that is entering the languid days of summer. We don’t expect too many changes to our fundamental economic picture in the coming months. But we fully expect to see “events” popping up to add some potentially unwanted excitement (volatility) to what could otherwise be the hazy, lazy summer days.

 

Betsey A. Purinton, CFP® is Managing Director and Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at bpurinton@strategicpoint.com.

The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.