Roughly $4.5 trillion has evaporated from the Chinese markets (FXI) since the middle of June – real, tangible wealth that no longer exists. Equities on mainland Chinese exchanges still trade at a median reported earnings multiple of 60+ times, according to Bloomberg. After direct government intervention in the country’s markets failed, China has now moved to cut interest rates and reduce bank reserve requirements, and this somehow has the US markets cheering. Does such irrational behavior by US investors finally mark the peak?
Here are 5 observations worth noting.
1. The Financial and Capital Markets are Fragile
If the Financial Crisis of 2008-2009 taught this generation anything, it was a lesson in the fragility of the financial and capital markets and the stages of denial as market developments unfold.
Many couldn’t have dreamed that Lehman would be wiped from the map, and Washington Mutual (“WaMu”) would experience the equivalent of a 1930s-type “bank run” in the 21st century. The reality is that the stock market will always be a function of human behavior–all the good and all the bad–and the banking system will always operate on the basis of leverage–banks will never hold enough capital to cover all deposits.
These dynamics are core to the financial and capital markets, but they also second in making them forever fragile and exposed to “crash-like” tendencies. The huge drops in the Dow (DIA) on Friday and Monday coupled with the bounce on Tuesday speak to a situation that bears watching closely. In our view, if this “reckless” market has rattled business and consumer confidence, it’s very likely we’ll start to see implications on the broader US economy.
It is well known that the stock market leads economic activity as both a measure of investor confidence and as a well-defined wealth effect (lower stock prices mean consumes feel less wealthy). Without confidence, business investment dries up and job growth slows (or even layoffs ensue), which impacts consumer spending, which hurts businesses, which then cut more jobs and so on. The probability that such a “fickle” market may have finally stemmed the marginal “animal spirits” required for incremental economic risk-taking has become elevated.
The risks of spillover effects from the “crash in the Dow” on the US economy are real.
2. Volatility Often Marks Tops and Bottoms
Though some of the best investors are able to call market tops and bottoms, for us mere mortals, the best we can do is “get close.” Most market technicians agree that “churning” action, or “tug-of-war” movements between up-and-down days over a period of time, usually indicates that market participants have reached a point of buying-selling equilibrium and that a change of “market direction” may be an eventuality.
The best measure of market volatility is the VIX, or the CBOE Volatility Index. Yesterday marked the biggest surge in the VIX in its history, with “implied vol” reaching the highest since January of 2009, incidentally just two months before we saw a sharp change in market direction upward following the March 2009 bottom. Our view is that the spike in the VIX yesterday will mark the end of this 6+ year bull market, give or take a couple months.
At the moment, investors seem to be torn between a) remaining in an overheated stock market, hoping to catch the last fumes of a bull market; and b) reducing exposure for an eventual valuation “correction” to historical norms. It remains not a matter of if the Federal Reserve will raise rates, but when–later this year or next should not matter for long-term investors. Rate hikes are coming.
Yesterday’s 1,000+ drop in the Dow at the open, a recovery back to nearly unchanged, followed by an ensuing drop to close down nearly 600 points has “change in market direction” written all over it.
3. The Moves in the Dow Are Striking
From our perspective, the 1,000+ point drop in the Dow was rather notable, and we think it was for most financial advisors, mom-and-pop investors, and portfolio managers that are forthcoming enough to admit it. Equity markets are supposed to be volatile, but not that volatile.
The corresponding bounce Tuesday representing a 500+ increase at the open in the Dow isn’t helping either. Financial advisors are planning for the long haul, and frankly, it’s difficult to explain away as “noise” such moves on some of the widely-owned equities. For example, General Electric (GE) opened down 22% yesterday, and it looks as if Apple (AAPL) touched $92 per share, nearly 20% below levels in which it is currently trading. This is a massive move for a $600+ billion company.
Though there’s no reason to panic in any market at any time, and we don’t think investors that were selling were panicking, but a 1,000+ drop in the Dow is meaningful. The sell-off has “broken down” almost every chart across every major index.
4. A Large Drop in Share Prices Does Not Mean Stocks Are Cheap
Price is what you pay for something, but value is what you get. Price never equals value, and both are moving targets. The price that one can buy stocks may have fallen ~10% from their all-time highs, but S&P 500 companies are still trading at lofty valuation multiples, both on a forward price-to-earnings ratio and EV/EBITDA ratio, indicating that shares are still expensive.
Think of it this way: you may be excited that Best Buy (BBY) has reduced prices on the latest-and-greatest, state-of-the-art television by 10%, but if you can still buy that same television at Amazon (AMZN) for 20% less, then buying from Best Buy still doesn’t make sense. Said differently, the television at Best Buy may have a lower price, but it still isn’t a deal. Prices aren’t yet low enough.
That’s the situation we’re facing in the equity markets today–shares have fallen, but they still aren’t cheap. Throw in the risks to forward earnings estimates from China-related demand and the knock-on effects in the US economy coupled with expectations for increased interest rates, the discount mechanism within any valuation context, and the case for being fully-invested in global equities falls short, in our view.
The sell-off was not a panic — it was mere profit-taking. When the sell-off truly begins, it will be difficult to ignore.
5. Listen to Your Financial Advisor (and Yourself)
If your financial advisor is doing his or her job well, he or she will understand your personal goals and risk tolerances, and whether you are comfortable with drawdowns that can reach 20% or more as the equity markets digest the vast gains over the past six years.
You and your financial advisor have put hours and hours into developing your plan, rebalancing it periodically as your goals and risk tolerances change. No three trading days in the market should have an impact on any long-term thinking, provided “long-term” is long enough, but now is as good a time as any to make sure that your goals and risk tolerances truly align with your personal preferences.
Some investors may not know that market observers are calling a 10% drop in the stock market “normal.” In some cases, however, this “normal” 10% drop has wiped out two full years of income for retirees. Please communicate with your financial advisor and ask the tough questions. The best ones will have great answers and be there to help you.
It’s your money.
Image Source: Mike Licht
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