The Stock Market is Headline News Again-What does it mean "This Time"?

February 8, 2016

 

As 2016 began, equity markets around the world took a beating right away.  It was the worst start to a calendar year in history.  What, if anything, does this mean, "this time"?

 

Let's examine some facts.  The Chinese stock market has been very weak since the middle of 2015 and had some very bad days in January.  The economic news out of China has been mixed, if it can be trusted at all.  So, now it's China, but in other periods, it's been Southeast Asia, Greece, Latin America, the US Debt  downgrade or other "causes" of weakness.

 

The Shanghai stock market stands about 30% higher than it was two years ago, but down 50% from its high last spring.  So, long term Chinese investors show a nice profit and short term traders are hurting.

 

Oil prices fell into the high $20s per barrel and now hover in the low $30s.  Maybe some long for the days in 2008 when it was $140 per barrel?  Oversupply will be enhanced by Iran returning to sell oil to the rest of the world. Added to a perceived slowdown in China these factors are credited with putting downward pressure on prices.  The market price of oil is now less than it costs some producers to produce the oil, so something will have to give.

 

What is surprising is the recent correlation between the daily price of oil and stocks.  Oil and other commodity prices usually move in a very uncorrelated manner to stock prices.  Now, at least on a daily basis, they seem to move in lock step.  The sample size is too small to draw any conclusions, but it makes for an interesting observation.

 

We have seen a rise in volatility in stock markets.  What does this mean, "this time"?  Weston Wellington of Dimensional Fund Advisors (DFA) says, "If you can accept dramatic price fluctuations as a characteristic of liquid markets then you have an advantage over other investors who are frightened over day-to-day swings in stock prices.  In other words, you know that markets are working normally, you expect periods like this, and they don't faze you."  He's right, of course.

 

Below is a chart showing how normal declines are. In the US since 1926 there have been 262 declines of 5% and 28 declines of 10% or more.  You'll note on the chart the average time horizon for each decline is very short-is it possible that the rapid decline in January was merely normal?  Likely.  It's also easy to see the rapid recoveries markets made after every decline of these magnitudes.  Overseas stocks seem to act similarly, though the history available is much shorter.

 

Source: Dimensional Fund Advisors

 

So what can we do to reduce volatility?  A balanced portfolio between stocks, bonds and cash provides a huge reduction in volatility.  Investing internationally helps as well-see the chart below where a global stock portfolio has the lowest volatility among 18 developed markets, the US and emerging markets as a whole.

 

 

Courtesy of Vanguard Group

 

Older investors might like to search for other stressful times on the following chart that shows the growth of worldwide stocks over 46 years.  Can you see the Black Monday drop of 23% in 1987?  Well, it's labeled so it's easier to find, but it looks like a blip on the chart.

Source: Dimensional Fund Advisors

 

So, what have we learned from all of this?  Although the financial media wants to scare investors into action, those who have a plan and stick to it get the most reward.  Remember, a typical news cycle is 24 hours and your investment horizon is years and likely decades long.

 

In spite of cries of "It's different this time" that we've heard too many times, it never is.  Sound principles of investing and strong discipline pay off.

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