Equity markets do have corrections. What we are experiencing now is nothing new or unusual.
Since I started in this business in September 1982 (the start of the bull market!), I have experienced eight full blown US equity market corrections including this one.
The worst was the “great stock market crash” of 1987 where the S&P 500 fell some 34 per cent and 20 per cent in just one day. The most benign was a two month affair in 1994 when the market dropped 9.5 per cent. Of the seven corrections, the average loss was 19.5 per cent and the average duration a little over three months.
So what was responsible for some of these sharp and scary market retracements? An unexpected rise in bond yields (1984), program trading/currency volatility (1987), economic downturn (1990), financial crises (1998), and political stalemate in Washington/concern over the euro (2011).
What all these corrections have in common is that equity markets eventually recovered and went on to hit new highs.
It’s true some market corrections can be a precursor to a bear market. Since 1982, the US has had two significant bear markets: The bursting of the internet bubble and 9/11 in 2000-2003 and of course the GFC in 2007-2008. The preconditions for those bear markets (extreme overvaluation, 9/11, recession and financial system meltdown) do not exist at this time. My sense is we are just undergoing another correction.
What to do? Well first let’s take a step back and separate fact from fiction. The precipitous decline of commodity prices, and uncertainties over China (its economy and its stock “market”), are calling into question the trajectory of global economic growth.
The fact is most developed world economies are in pretty good shape. There is scant evidence economic growth is about to slump, either in the US or other advanced economies. Manufacturing activity has accelerated a bit in the Eurozone and Japan in the past month.
In the US, retail sales, durable goods, and housing data have been positive. Economists surveyed by The Wall Street Journal expect the government to revise that second-quarter GDP figure up to 3.3 per cent. Employment continues to expand. Consumers are generally upbeat.
Economic expansions end when central banks raise interest rates significantly to head off inflationary pressures, or because of some sort of exogenous shock like a financial crisis. Both are absent here. Even though the job market continues to improve and unemployment is approaching the magic “full employment” 5 per cent level there has been no upward pressure on wages which is a precursor to inflationary pressures – the anathema of central banks everywhere.
In Europe, the economic outlook is one of ongoing recovery underpinned by the European Central Bank’s bond buying policy as part of its “quantitative easing” policy launched earlier this year. The fall in the euro has made EU exports more competitive.
Equity markets historically have stumbled when a more palatable alternative presents itself. Usually this involves cash or bonds. In the US it’s unlikely “zero plus” cash rates or 2 per cent Treasury yields present much of an attraction. While European markets and possibly property might attract some US equity assets, I suspect the majority of money will stay in equities in the home market.
As for China, forget about watching its stock market for any clues because it’s not a real market! The clumsy efforts of the Chinese government to intervene in its equity markets haven’t helped either. The mainland China equity market is full of large government-controlled businesses and industries, fuelled by retail investors’ margin-fuelled rampant buying and selling, and basically closed to global investors except for a small slice. It has no connection to the real Chinese economy.
As for the Chinese economy, well that’s another thing since China can account for as much as 15 per cent of world economic output and has contributed (along with other emerging markets) as much as half of the world’s growth in recent years.
That said its impact on other countries around the globe is somewhat overstated. China exports more than it imports, so a slowdown in its growth has a limited impact on its trading partners. Exports to China amount to less than 1 per cent of GDP for the US, UK, France, Italy and Spain, 2.6 per cent for Germany and 2.7 per cent for Japan, according to Peter Berezin of BCA Research.
In fact the correlation between US economic growth and Chinese growth is relatively low according to Goldman Sachs in a recent report. Goldman estimates that a one percentage point drop in Chinese growth would translate into a miniscule 0.06 percentage point reduction in US GDP.
My sense is, that unlike its bumbling attempts to stabilise its wonky equity markets, China will eventually make headway in guiding its economy toward more consumption-led growth. In the name of political stability it has to. As well, it has a lot of “levers” to pull – monetary, fiscal, and structural. Recent attempts to peg its currency, while misunderstood by many, are an attempt to make its exports more competitive. Where and when will it stabilise? Who knows? Possibly at a 4 or 5 per cent steady state of GDP growth into 2016/2017. Not the worst thing.
The problem with corrections is that there is no hard and fast rule as to when they will end. Markets could fall another 5, 10 or 20 per cent from here or recover tomorrow. No one knows and if they say they do they are “full of it”.
Eureka Report overseas investors must take the long view and work out if the underlying investment thesis for each stock held is still valid and intact. If so then this is “just” a correction and also a buying opportunity!
Investors should also realise that markets will now undergo a “bottoming” process that may take a few weeks, one month or even six months, until it finds a level from which to recover. Stock prices will continue to be volatile on a daily basis presenting risks and rewards.
When I look at the 34 companies that I have been following for subscribers, very few are dependent on commodity prices or strong economic expansion to meet and beat expectations. As well I’ve tried to provide a group of companies diversified by industry, market capitalisation, and risk profile.
So for investors that can take the daily volatility of our “disrupter” group, I suggest picking up some of the following “high flyers” over the next few weeks on weakness:
FireEye or Proofpoint
More conservative investors should consider:
Or of course you just could also pick up our 10 company International Model Portfolio and get some of both groups!
Given the recent price decline, I am also now putting Ambarella back to a buy. Try and get it below $US90.00. It has come off some 30 per cent from its recent high. Story and thesis intact.
Netflix was off 20 per cent in five days at one point last week and also one to watch. It’s still up 100 per cent YTD though. One to buy if it gets well below $US80.00.