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MEO Special Report

The recent market drawdown may not be as dramatic as it appears. Investors who stay on plan have historically been rewarded for their fortitude and patience.

Economy and capital markets

Stock Market Correction Is Overdue; Investors Should Stay on Course

  • 8/25/2015

The S&P 500 just experienced its first -5 percent week since September 2011, with the week ended August 21 down 5.8 percent. The decline continued Monday morning with the broad markets falling in the opening minutes of trading.

On an absolute basis, these point declines appear breathtaking, but they need to be viewed in perspective. For example, the Dow Jones Industrial average declined 530 points on Friday, August 21. On Black Monday, October 19, 1987, the Dow Jones average declined 508 points. However, the August 21 decline in percentage terms was -3.1 percent versus -22.6 percent in 1987. Last week’s decline was swift and deep; 10 percent drawdowns typically happen once per year. We have gone more than three years without a 10 percent correction, which makes last week feel worse than the historical experience.

August 2015 Special Report MEO Small Stock Market Pullbacks are Normal

According to Bespoke Investment Group, 5 percent plus weekly declines have occurred 28 times since 1980. The 5 percent plus weekly market drops are often accompanied by recoveries over the next three months. The exceptions appear to be new bear markets like 1987, 2000 – 2002, and 2008 – 2009, in which cases the recoveries were longer, but recoveries nonetheless.

U.S. economic fundamentals strong despite China

The fundamentals of the U.S. economy remain firm — housing prices, employment, manufacturing, and auto sales are solid. In fact, this may be the first year in the recovery where the economy is actually stronger than the U.S. stock market.

Investors may be worried about the signal China’s leaders sent in devaluing its currency by 2.5 percent relative to the U.S. dollar. China’s growth, which is important to the world economy, especially the Eurozone, has been waning. This declining growth has impacted commodities, with copper, oil, and other industrial commodities off 30 percent or more. Commodity exporters like Brazil and Russia are feeling the effects, with their currencies off 20 percent or more relative to the U.S. dollar.

There is a significant amount of emerging market debt denominated in U.S. dollars, so declining home currencies could be another problem for certain borrowers. The on again/off again talk about the U.S. Federal Reserve interest rate policy is also causing uncertainty, while the U.S. presidential race has mavericks in both parties upsetting the political norm. All of these uncertainties, coupled with above-average stock valuations, are providing a reason for investors to reduce risk.

Using time to manage volatility

We caution against overreacting to short-term volatility. Time horizon is an important ally for the individual investor, which is a big advantage over the computers and hedge funds trading stocks furiously each market day. While one-year returns are basically a 50/50 proposition, the odds tilt in favor of the long-term investor 5, 10, and 20 years out.

August 2015 Special Report MEO Investment Time Horizon Manage Volatility

In addition to the solid fundamentals of the U.S. economy, corporate balance sheets may provide a floor under the U.S. stock market, with current record levels of cash sitting on the balance sheets of corporate America. Monday morning on CNBC it was reported that a major trading desk said “our buyback desk is the busiest this morning that we have seen in years.” This tells us that corporations may be taking advantage of the recent pullback to buy back their shares on previously announced buy-back plans.

August 2015 Special Report MEO Corporate Cash Percentage Current Assets

Combating market volatility

Diversification and disciplined re-balancing are two keys to combating market volatility. While the asset allocation portfolio has never been the best performer, it has also never been the worst. By staying in the middle and re-balancing periodically, we maintain that the diversified investor has greater ability to stay on plan. Those who can stay on plan historically have been rewarded for their fortitude and patience. Bull markets typically end with a recession approaching. U.S. economic data does not support that a recession is near. Thus, we believe this is a market correction versus a new bear market.

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