Is This the Way the World Ends? A Look at January Market Volatility
With the recent market declines both abroad and here in the U.S., there is increasing fear that this is it—the big one that will take us back to the depths of 2008. Although that level of fear is certainly understandable, a closer look at the real economic and market situation around the world suggests that the volatility we are now seeing—and that we may well continue to see—is perfectly normal. Indeed, this kind of volatility is why stocks can, over time, yield the returns they do. Which means that these periodic declines are not only normal, but necessary.
This, however, does not really answer the question. How normal is this current decline—and how would we know if we are headed back to 2008? Is there a way to tell?
How normal is this decline?
Let’s start with the easy question first. Right now, we are down about 9 percent from the market peak. Since 1980, declines during a calendar year have ranged between 2 percent and 49 percent, with the average decline at just over 14 percent. So, the market could drop another 5 percent, and we’d still only be at the average decline for a typical year.
Another way to look at this is to see how often a decline of any given size occurs. Markets experience a 10-percent decline every year, on average, and this is only the second we’ve seen in the past three years. In that sense, we are overdue, but how much worse can this get?
How can we tell if we’re headed for another 2008?
There are no guarantees, of course, but if we look at past bear markets (defined as declines of 20 percent or more), we can make some observations.
First, of 10 such events since 1929, 80 percent of them happened during a recession. The U.S. economy, despite some slowing trends, continues to grow; we are not in a recession. A growing economy tends to support market values and limit declines.
Second, 40 percent of past bear markets came during times of rapidly rising commodity prices—the 1973 oil embargo, for example. Rising prices tend to choke off economic activity and slam profit margins. Now, of course, we have low and dropping commodity prices, which encourage economic growth and help profit margins, at least here in the U.S. This is, overall, the opposite of a problem.
Third, during 40 percent of past bear markets, the Federal Reserve (Fed) aggressively raised interest rates. With rates still one step from zero—and likely to stay very low for some time—we again have the opposite conditions from those that fuel a bear market. The Fed continues to add stimulus to the economy, which has supported the market so far, and will continue to do so. Rather than being part of the problem, this Fed is determined to remain part of the solution.
Finally, half of the bear markets were born when market values were extreme. Current valuations are high, but they are nowhere near previous peaks. In fact, although an adjustment to lower valuations is painful, as we are seeing, it also means the risk of a further drop dissipates, which takes us back to the fact that periodic drawdowns are not only necessary, but healthy.
Almost all bear markets have more than one of these traits; right now, we have (at most) one and really more like one-half of one. In fact, for two of these traits, we actually have the opposite of a problem. This doesn’t mean that we won’t see further declines, but it does suggest that they are less likely—and would probably be short-lived.
We can also look at recent history to see how much more trouble we might see if the situation does worsen. In 2011, when Greece almost declared bankruptcy and broke up the European Union, for example, we saw a pullback of 19 percent, which almost met the standards of a bear market. In 1998, during the Asian financial crisis, we also saw a pullback of 19 percent. Despite the headlines, our current international economic situation is nowhere near as bad of either of those years. And even with those declines, the annual return for each year wasn’t disastrous: in 2011, the market ended flat, and in 1998, it actually gained 27 percent.
So, what can we expect in 2016?
It does not seem likely that we will see that kind of gain in 2016, but it also does not seem likely that we will see a massive and sustained decline that takes us back to 2008. Worst case, if the Chinese situation gets as bad as the Asian financial crisis, or the Greek crisis, we could see additional damage, but we probably won’t see anything worse than what occurred during those pullbacks.
With a growing economy, with strong employment and spending growth, and with low oil prices and interest rates, the U.S. is well positioned to ride out any storms. More so, in fact, than we were in 2011. As the island of stability in the world, we are also very attractive to foreign investors—as we can see by the strength of the dollar.
By understanding the history and economic context of today’s turmoil, it is clear that although markets may get worse in the short term, the foundations remain solid, which should lessen the effect and duration of any further damage. Yes, the headlines are very scary, but things actually aren’t that bad. So, we will be postponing the end of the world . . . again.
Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged, and investors cannot invest directly in an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is no guarantee of future results.
Authored by Brad McMillan, CFA®, CAIA, MAI, chief investment officer at Commonwealth Financial Network.
© 2016 Commonwealth Financial Network®