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August 24, 2015

Market Rout Rattles Investor Confidence

Last week’s stunning drop in global stock markets, occurring when much of Wall Street was on vacation, brought back painful memories of the historic 2008 to 2009 near -50% collapse of the S&P 500. That decline wiped out a large…

Market Rout Rattles Investor Confidence

Last week’s stunning drop in global stock markets, occurring when much of Wall Street was on vacation, brought back painful memories of the historic 2008 to 2009 near -50% collapse of the S&P 500. That decline wiped out a large chunk of retirement savings, particularly for those investors who sold out and missed all or part of the market’s subsequent six-year rally. The ride since then has been relatively smooth, with only a few bouts of serious weakness. The sense of complacency that has accumulated over that time probably made last week’s 5.8% drop in the S&P 500 seem even more shocking.

But should a sharp pullback from the peak in the U.S. stock market be viewed as an unexpected event? The answer is no. Despite its swiftness, long-term equity investors should be well-acquainted with this kind of volatility. What is unusual about the market’s behavior is the length of time that has passed since the last dip of 10% or more, which occurred back in the third quarter of 2011. Part of the price of enjoying the competitive returns of equity investments over the long term is to endure the occasional bouts of stomach-turning declines. To settle their stomachs, investors use high- quality bonds in varying quantities as the Pepto-Bismol of their portfolios.

As we have stated in the past, predicting the precise timing of market corrections is a fool’s errand. The experts who will be crowing on TV this week about predicting the decline, have, in most cases, been blaring the same warnings for years, costing investors millions who have followed their advice. At South Coast, we have been talking about more normal volatility coming back into the market for the last year. Our advisory council has adopted a theme of “sailing ahead in choppy seas,” intended to highlight the possibility of a rough ride during the year, but with a positive result by year-end. We continue to view that as the most likely outcome.

The critical question now is “how bad could this get?” For clues to the answer, we must review the three main drivers of stock market performance: fundamentals, valuation, and psychology. Despite the disappointing news coming from China that ignited the market’s decline, we believe that global economic fundamentals remain largely positive. China’s economy is slowing, but we do not believe it is collapsing. European economies are experiencing a modest recovery. And conditions in the U.S. remain on a positive track of slow and steady improvement.

We do not view the collapse in commodity prices as a harbinger of economic doom. In fact, lower energy prices are a boon to countries that consume more energy than they produce (such as the U.S. and China). In short, we do not see a global recession on the horizon.

U.S. equity market valuations were stretched, but not extreme, prior to last week’s selloff. We have noted in the past that unexpected negative events can exacerbate a market decline when valuations are high. Based on our forward 12 month estimate of S&P 500 earnings, the U.S. stock market now trades for about 15 times earnings, an attractive level given the low interest rate environment. Emerging market valuations are significantly lower than that. Our conclusion is that valuations are not the headwind to further appreciation that they have been.

Psychology is harder to predict. Remembering the bruising declines of the Great Recession, many investors may ignore the fundamentals and head for the sidelines “until the dust clears,” which is usually after the market has staged a confidence-restoring rally. As a result, more declines in the short run are quite possible.

Our best advice is to ignore the short-term predictions of the TV pundits. Focus on the long-term earnings power of your investments and the cost of acquiring that earnings power. And make sure you keep the right amount of Pepto-Bismol on hand.

Important Disclosures:

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaran- teed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as on the date of this document and are subject to change.

There are inherent risks with equity investing. These risks include, but are not limited to stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.

Investing in international markets carries risks such as currency fluctuation, regulatory risks, economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.

All investing is subject to risk, including the possible loss of the money you invest. Diversification may not protect against market loss or risk.

Past performance is no guarantee of future performance.

Index Definitions:

The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

Commentary provided by Bruce Simon CFA, City National Rochdale – Special Bulletin, August 4, 2015.

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