You Say Tomato, I Say Tomato

It Happened

It finally happened. After four years of useless banter in the media and speculation from day traders, we finally got what so many had anticipated for so long. The S&P 500 corrected this week.

On Wall Street, a “correction” is defined as a drop in price by more than 10% from a high. We had not seen a correction in the S&P 500 index in over four years, and those who focus more on the short-term movements in equity prices rather than the long-term fundamentals have been obsessed with trying to time the next correction.

 
Why such intense focus by both traders and the media? Prior to the correction we saw this week, there had been 27 corrections in the S&P 500 since the end of World War II. Divide the number of corrections by the number of months since then, and the result is an average of one correction every 20 months or so.

 
Therefore, pundits kept insisting that we were due for a correction simply because one hadn’t happened in a while. Well, we got it on Monday, and three catalysts ignited the selloff:
1. China: Chinese stocks and moves by their government to devalue the currency has created nothing short of panic that the world’s second largest economy is slowing down.
2. Commodities: Most commodities are under pressure due to supply gluts and fears of a global economic slowdown. Oil has grabbed most of the headlines, as prices have fallen below $40 in the U.S.
3. Fed: Global financial markets have been dominated by U.S. interest rate speculation all year. Many had expected the Fed to raise rates in September, but now it appears that traders are moving their bets out into 2016.

 
When it comes to fear and panic, this correction certainly did not disappoint. U.S. equity markets opened Monday with so many sell orders that brokerages were unable to execute trades due to the increased activity. In fact, several investors could not even access their accounts online because of the spike in internet traffic.

 
The inability to access accounts actually turned out to be a blessing in disguise for those who succumbed to the temptation of panic selling. Several high quality stocks opened down 20% only to recover within minutes. Had they been able to access their accounts and trade with ease, they would have locked in gut-wrenching losses.

NOTE: Those who use “stop losses” when buying stocks learned a horrid lesson this week, because setting these predefined sale prices on equity investments did nothing but add fuel to the fire. While stop losses are often used by short-term traders, they are one of the easiest ways to lock in unnecessary losses for long-term investors.
While the reasons for the massive spike in volatility will most likely remain in the headlines for the foreseeable future, many investors are asking just how bad it is out there.
Hence, let’s walk through each of these catalysts in order to get a better idea of the true impact to investors.

China

The madness out of China is a great place to start simply because it appears to be the straw that broke the camel’s back. A perfect storm has hit China in recent weeks from the government’s currency devaluation, equity markets tanking, and recent economic data indicating a slowing Chinese economy.

 
Those who have believed that China is a house of cards are now taking every advantage to tell anyone who will listen, “I told you so!” However, their victory laps are premature for three reasons:
1. Disassociation: China’s equity markets are completely disassociated with its economy, and the the overwhelming majority of Chinese citizens either don’t own stocks or own a very small percentage relative to their overall net worth. Therefore, paper losses should not have a material impact on their spending elsewhere in the economy.
2. Consumer vs. Export: China is working hard to shift from an export-oriented economy to a more consumer-oriented one, where the growth comes mostly from consumer spending and services (similar to America). This process will take time and experience growing pains along the way.
3. Moving in The Right Direction: Allowing the market to determine the value of China’s currency only benefits the rest of the world in the long run. Although the changes being made by their leaders have caused short-term volatility, they are a move in the right direction for international trade and competitiveness.

 
China’s economic growth may be slowing, but they are still the second largest economy in the world and growing almost three times faster than the U.S. Those who view China through a myopic lens are missing the fact that what’s good for China’s economic future is good for us all.

Commodities

The law of supply and demand govern commodity prices in the same way it determines prices of all other financial assets. Changes in these two forces cause commodity prices to do two things over time – go up and go down.
When commodities fall due to weak demand, it’s usually a bad sign because an economy is likely shrinking. However, when prices fall due to an increase in supply, there are times when cheaper commodities are a good outcome for an economy.

 
For example, although the energy sector has caused tremendous volatility all year long for stocks, I fail to see how cheaper gasoline is a bad outcome for consumers. Our economy is 70% consumer spending, so reallocating dollars from the pump to other areas of our economy is overwhelmingly a net benefit.

 
I also don’t see how cheaper electricity costs for companies can hurt our economy. The U.S. currently has the cheapest electricity costs in the developed world, which is one of the key drivers for manufacturing jobs coming back to the U.S. New jobs reduce unemployment, which leads to more consumer spending and tax collections by governments.
Simply put, pretty much everyone except poorly run energy companies wins in the long run when energy prices remain low.

Interest Rates

It sure feels like we can’t go a day without talking about interest rates and when the Fed will ultimately raise them for the first time since 2006.

 
The focus has become so intense that there are computer algorithms trading billions of dollars in fractions of a second due to the number of adverbs used in statements released by the Fed. Every word from the Fed is analyzed, and traders working to time the Fed’s movements are causing major swings in global asset prices.

 
However, I fail to see how rising interest rates in an environment where retirees are unable to earn a return on cash investment is a bad outcome. For that matter, the Fed will only raise rates when they feel that the economy is strong enough to support the move, so why would an investor fear a healthier economy?

Implications for Investors

The volatility experienced over the past two weeks is being driven by fear and panic. There is simply no logic and/or fundamental reasoning that I can find to tell me otherwise.

 
Will the volatility continue to drive markets lower over the coming weeks? I truly have no idea. Emotions are running high right now, and the panic selling may very well continue.
I can’t predict temper tantrums in markets with any level of statistical accuracy for the same reason I can’t predict an impending meltdown from a two year-old. All I can do is focus on fundamentals and assess the real risk for investors.
Within this context, I take a step back from the panic and look to recent data that is relevant and far more predictive than fear and panic:
• Strong Economic Data: Consumer confidence surged in July, recent GDP numbers, and housing data continue to trend in a very positive direction.
• Real China Data: While traders were watching highly suspect economic data coming out of China, sales data from U.S. companies with high exposure to China tell a very different story. For example, Apple management stated that sales and demand have never been higher for them in the second largest economy in the world.
• Recession Risk: Arguably, the most important point to keep in mind is that although the market’s temper tantrum over the last two weeks has been nothing short of violent, the risk of a recession remains very low.

 
Not surprising, these relevant points that are supported by data and fundamental analysis are being ignored at the moment because traders are operating on fear, and their biases are getting them “lost in the weeds.”
The bottom line is that short-term traders have every right to be concerned with this volatility, but long-term investors should sit back, relax, and wait for more stocks to go on sale.