It’s not as if investors didn’t already have enough to worry about with the Greek crisis, Puerto Rico’s default, the Iranian nuclear agreement, ISIS, the Fed ending its zero-interest-rate policy in the near future, and gurus such as GMO’s Jeremy Grantham proclaiming that the market is vastly overvalued based on the Shiller CAPE 10 ratio. But we now have alarm bells going off from the world’s second-largest economy, China, where slower economic growth is expected.
Concern over slower growth in China has led to sharp sell-offs in many emerging market countries. Those concerns spilled over to the markets of developed economies last week. After closing at 2,012 on Monday, Aug. 17, the S&P 500 fell 0.5 percent on Tuesday, another 0.8 percent on Wednesday, 2.1 percent on Thursday, and 3.2 percent on Friday.
That’s a total loss of roughly 5.3 percent in those last two days, and a total loss of 6.3 percent in four days. That made it the worst weekly loss since 2011. Further, the drop of almost 4 percent for the S&P 500 on Monday, Aug. 24 increased the total loss over five days to 9.4 percent. That’s certainly enough to scare many investors.
While there surely is risk that the markets will fall much further, the prudent strategy is to stick with your well-thought-out plan, one that has already anticipated events like those of the past few days because they have happened many times before.
Consider the evidence from a study by Benoit Mandelbrot and Richard Hudson, which found that the stock market exhibits far more extreme events than would be expected if returns are normally distributed like we see in the famous bell curve.
We can also see evidence of this in how investment returns are not earned smoothly. While the S&P 500’s average annual return has been 12 percent, you can see from the charts below that there are very few years with returns close to the average.
The lesson here is that it would have been virtually impossible to earn those long-term returns of just over 10 percent per annum without having the discipline to be present all the time.
Deja Vu All Over Again
We know that crises are pretty much the norm. Their existence explains why the equity risk premium has been so high. Investors demand a large premium to take the risks of owning stocks. So the question to ask yourself is: How much equity risk do you have the ability, willingness and need to take?
Having reviewed the historical evidence, let’s turn to the current situation and try to explain what is going on and what the risks are. What we are experiencing now reminds me a lot of what came to be known as the Asian Contagion, which began in the summer of 1997 and culminated in a large drop in stock markets around the globe in the summer of 1998.
It ultimately led to the demise of the largest hedge fund in the world (at that time), Long Term Capital Management. From July 20, 1998, until Oct. 8, 1998, the S&P lost almost 20 percent.
In the month of August alone, the MSCI EM Index fell almost 29 percent. That crisis began with a currency crisis in a minor country in Asia—Thailand—and eventually spread to most of the emerging markets in the region. Russia defaulted on its debt, and there was a banking crisis in the United States.
Today few remember what happened, let alone what caused the problem, and investors who bailed out likely missed the ensuing strong rally that occurred.
The similarity with current events is not only that this crisis began in the Far East, but that it also follows a period of very easy monetary policy by the Federal Reserve. In both instances, very low rates encouraged many investors to take more risk than was prudent for them.
In addition, prior to the Asian Contagion, the S&P 500 Index had experienced only one single calendar year with a loss since 1982—just over 3 percent in 1990. Similarly, today’s investors haven’t experienced a loss in the S&P 500 since 2008—despite the fact that the S&P 500 has experienced a loss in 28 percent of the calendar years since 1926.
Balancing Complacency And Fear
Bull markets make investors complacent. Many forget that investing in stocks is always very risky. Then when the risks show up, those who took too much risk typically react by panicking and selling. And that often leads to sharp drops in very short periods.
So it wouldn’t come as a surprise to me if we see another contagion, with risky assets—such as emerging market bonds, high-yield debt and stocks (including dividend-paying stocks, which many investors have been using as substitutes for safe bonds)—all being sold off in a flight to quality.
There are certainly good reasons to be concerned, but that’s always the case. Investing in stocks is always risky, and if you ever think that isn’t the case, it’s likely because you have become complacent due to a run of good returns and you are ignoring the historical evidence.
With that in mind, let’s look at some of the issues confronting today’s investors. Since the drop in the markets has its origins in China, we’ll begin there.
Back To The Source
In the first part of August, output in China’s manufacturing industry contracted at the fastest pace since the depths of the financial crisis. The August reading of 47.1 points, compared with 47.8 points in July, was its lowest reading since March 2009. Note that any figure below 50 indicates contraction.
The greater-than-expected slowdown in China has led to a drop in demand for all industrial-related commodities. This comes at a time when the revolution in technology related to fracking led to a massive increase in the supply of energy. That has led to a sharp drop in energy-related commodities, which are all priced in U.S. dollars.
There are many countries—especially many of the emerging market countries (such as Indonesia and Chile, as well as Russia)—that are major exporters of commodities. They have seen their exports fall sharply, causing their currencies to fall as well. The loss of dollar revenue is made more critical by the fact that many of these countries, and companies in those countries, have much of their debt denominated in dollars.
These problems have been exacerbated by the Chinese government’s recent decision to allow the yuan to float downward (a logical outcome of a weaker economy).
Most Asian economies depend on China for much of their exports. The slowing of the Chinese economy along with the devaluation of the yuan has been a double whammy, putting further pressure on their economies and stock markets because their domestic producers must now compete with cheaper Chinese exports. Again, the situation reminds me of what happened in the summer of 1998.
Beyond Emerging Markets
It’s also important to note that the emerging countries aren’t the only ones to be negatively impacted. Developed nations that are major commodity exporters, such as Canada and Australia, have been adversely affected, and the results can be seen in the sharp declines in their currencies. Relative to the U.S. dollar, the Australian dollar has fallen in value by about 45 percent, and the Canadian dollar by more than 36 percent over the last four years.
Another concern is the ability of governments and central banks to deal with another potential contagion. Because of all the fiscal and monetary stimulus that has already been applied, and because interest rates around the developed world have little room to be lowered, there aren’t many bullets left in the arsenal to fight a contagion, certainly not as many as were available when the 2008 financial crisis hit.
But before you jump to the conclusion that all this bad news means you should reduce your equity allocation, we need to discuss some important issues. And we’ll do that in Friday’s post.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.