“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
― Benjamin Graham
What a start to the new year for investors! By early January, all major stock market indices around the world were in the throws of a major sell-off. In the US, the S&P 500 shed 8% of its value in the first two weeks of the year. Meanwhile, here in Canada, our benchmark S&P/TSX Composite index quickly fell into bear market territory, continuing on a downward slide that had started back in April 2015. (Note that a bear market is defined by one that has dropped in value by 20% or more from its latest highs).
Investors got a short reprieve from all the turbulence in late January when there were rumors the Saudis had entered discussions with Russia to agree on a cut in oil production. It also helped that the Federal Reserve turned less hawkish on its commitment to continue raising interest rates in the US. But, the bounce was short lived and back down the markets went.
All in all, it has been a pretty scary start to the new year – apparently the worst ever in market history! So what is causing such market angst? For sometime, there have been a number of cross-currents buffeting markets and causing recurrent bouts of volatility. In many respects, what we are seeing is a continuation of this reality, just intensified.
Slow-down in China
Top of the list of concerns today is the slowing pace of growth in China, now the world’s second largest economy. To a great extent, slower growth in China was expected as it transitions from an industrial economy to one that is more consumer focused. Problem is the transition has not been a smooth one, causing some to question the ability of the Chinese government to keep the economy on course. With the latest devaluation of the Renminbi, and other policy bungling, worries over a possible hard landing in China have escalated.
The bottom of the barrel
Then there is the collapse in oil prices, a simple problem of oversupply, but one that has proven very slow to correct. In truth, most market watchers never expected oil to go as low as it has, dipping below $30 USD per barrel (WTI). Nor did anyone expect oil to remain low for so long. At current prices, all producers, even the Saudis, are losing money, and lots of it. This is putting tremendous pressure on many of the oil-producing nations, particularly those in the emerging markets (Russia, Brazil, Venezuela etc.), and any trouble in the emerging markets is ultimately not good for the Chinese economy. There has also been concern over potential bankruptcies, and the resulting stress on banks with loan exposure to the oil sector. Needless to say, markets will breathe a big sigh of relief once oil prices finally start to stabilize.
Diverging monetary policy
Another important catalyst in all this, has been the gradual tightening of US monetary policy. That started a couple of years ago with the tapering of the Federal Reserve’s program of quantitative easing (QE), an aggressive form of monetary stimulus. Problem is, after several rounds of QE over a number of years, the markets had become accustomed to, and perhaps too reliant on this stimulus. So as the Federal Reserve continued to unwind QE, increasing bouts of volatility ensued. Simply put, where there is weaning, there is often crying.
Then last year, as the world prepared for the expected hike in US interest rates, the first in 7 seven years, central banks in the Eurozone and Japan were ramping up their own QE programs and moving to negative interest rates.
This glaring divergence in monetary policy caused a tremendous surge worldwide in the value of the US dollar, leading to some worrisome dislocations in financial markets. Particularly affected are the markets of emerging economies where the growing phenomenon of dollarization is more prevalent. (This is the adoption of the USD as legal tender in jurisdictions outside the US). So it would appear that what is good for the US, in terms of monetary policy, is not necessarily good for the rest of the world, and central banks will need to go back to working in concert with one another. The Federal Reserve’s next move in one that investors will be paying very close attention to.
The voting machine
To put all this into context, we are now in the 7th year of a bull market that began mid-2009. At this stage in the cycle, valuations are high, and probably unreasonably so given the persistently slow rate of economic growth in the developed economies. So at this point, it is natural for stock markets to be more reactive. And of course reactive they are!
But does this all amount to a more serious downturn in the making…signaling a global recession to come? Given the extreme volatility we are witnessing, one would not be faulted for wondering. (Never mind that the stock market has “predicted” 27 of the past 11 recessions!)
Certainly, if this is a global bear market in the making, it is not a typical one. Valuations have been high, but nothing akin to a bubble. Think of the dotcom craze in the late ’90’s and the US housing frenzy of the mid-2000’s.
On the economic front, fundamentals remain mostly positive. So there is no clear indication we are headed into a global recession – not unless we collectively panic ourselves into one!
Ultimately, markets go up and down, and then up again, in a constant push and pull between buyers and sellers. This is the “voting” machine that Ben Graham, the father of value investing, has spoken of. In the current market environment, where so much uncertainty prevails, market participants will continue to cast their ballots, creating lots of volatility. And this is not such a bad thing! Because, for the judicious investor, market volatility also creates opportunity, that value gap which only becomes truly apparent in the longer run, once the “weighing” machine kicks in.
