Market Volatility:

Market activity today has been ugly, with U.S. markets down over -5% at one point, following weak overnight results from Asia.  Local China A share markets fared much worse, losing nearly -10% on the session, wiping out this year’s gains.  However, prices seem to have recovered a bit in the last hour from the very uninspiring start at the open.

It’s important for clients to keep the appropriate perspective with these types of events:

§  We’re now in ‘correction’ territory, as measured by the previous highs for the S&P, Dow, etc.  Market corrections of -10% or so have usually occurred about once a year.  More severe drawdowns (-15% to -20%) are less common, but can and should be expected every few years.  Since we haven’t experienced much of a correction at all in about four years, we were long overdue.  Naturally, the longer we go without, the more surprising and off-putting the actual event can become…it’s surprisingly easy to get conditioned to low volatility.

§  Market declines are emotional events, driven by fear.  We know as much intellectually, although the academic ‘efficient market’ theorists don’t have a great way of modeling human behavior during these types of events.  A typical catalyst is uncertainty, which causes some investors to sell first and ask questions later, figuring that the person next to them might know something (bad) that they don’t.  They usually don’t, but no one waits to find out.  That’s also why corrections can be quick in relative terms, and can often recover quickly once reality is sorted out.

§  What about China?  Most corrections have a newsworthy ‘reason’—this time, it’s China.  They have gone/are going through major growing pains as they not only settle in from exponentially high into more moderate, manageable economic growth, and are trying to gradually integrate in a variety of free market reforms.  The currency devaluation was the surprise that spooked some people (although the effect was much less dramatic when viewed from a wider lens).  Stock investments are a new novelty for investors there and the resulting bubble and pullback created more euphoria and despair than many were used to (if some there considered it ‘casino-like,’ the volatility recently hasn’t disappointed).  Local ‘A share’ trading has less impact on U.S. investors than other global markets due to the limited non-Chinese participation, but volatility anywhere is rattling.

§  As we’ve touched on before, China’s fundamental condition shows growth, but slower growth.  This hasn’t been helped by what appear to be contradictory/inconsistent government policies put forth in attempts to ‘manage’ markets.  Free markets, by design, are difficult to manage to that degree—hence the name ‘free’—so this is a process that will take more resources and careful decisions as they continue to intervene.  As a command-and-control economy and government system, old habits die hard, so officials feel an intense pressure to ‘do something’ to maintain expectations and social norms.  In contrast to other nations in prior emerging market crises, China has an ample supply of funds at its disposal to use in this effort.  We found out this morning that the government is allowing pension investments in equities for the first time, in a step away from traditional bank deposits and T-bill-like instruments.

§  It all comes back to fundamentals when we take a step back from this market drama.  There has been some exuberance in certain areas of the U.S. equity markets, including some fringes of biotech and social media, which have been the darlings as of late.  But many other areas have been far more tempered, as has typical investor sentiment.  Market valuations have risen, but also remain within historical ranges, when looked at from a variety of equity-based and asset class-relative metrics.  Red flags such as overdone credit expansion and high commodity prices are notoriously absent from this cycle.

§  Will this affect the Fed?  It’s certainly possible.  While the U.S. growth picture has warranted a non-zero monetary policy for some time, and especially now with low/moderate growth, the timing of such of an event is likely the main discussion point.  At the current pace of things, the key consideration is that the Fed can start earlier and raise rates gradually, or start later and raise them more dramatically down the road.

LSA will be releasing our full article shortly but wanted to give some insights to the paper.