Like a full plane hitting a rough patch of turbulence, investors have been shaken by the recent price volatility in the stock market over concerns of a slowing Chinese economy, plummeting oil prices, and a host of other alarming headlines. As a result, investors are left picking up the pieces of the S&P 500 decline, which currently sits off -11% from its 2015 highs (down -15% at the 1/20/16 low). The picture looks even uglier if you consider the Russell 2000 small cap index, which has collapsed -21% from its 2015 highs (-26% at the 1/20/16 low).
What now, and what does this mean? There has been all kinds of crazy technical trading activity occurring around heavy options expirations, stop-loss selling, and short cover buying. With all the frenetic gyrations in the stock market (e.g., 2,000 point swing in the Dow Jones over the last month), there have been no shortage of opinions on TV, on the internet or at the watercooler. However, the best sage advice probably came from 86-year-old investor legend, John “Jack” Bogle (founder of Vanguard Group – $3.4 trillion in assets under management at 12/31/15), who emphatically told investors to “Don’t do something…just stand there!”
The advice to “stay the course” can be very counter-intuitive to human nature. In periods of stress, our brains tend to revert back to our ancestors’ Darwinian survival instincts, which tell us to flee from the ferocious lion (see also Controlling the Investment Lizard Brain). The fact is these periods of turbulence are normal – no different than a bumpy flight into San Francisco. In fact, we’ve hit quite a few choppy air pockets in recent years:
- Debt Downgrade/Debt Ceiling Debate/European PIIGS Crisis (-22% in 2011)
- Arab Spring/Grexit Fears (-11% in 2012)
- Fed Taper Tantrum (-8% in 2013)
- Ebola Outbreak (-10% in 2014)
- China Slowdown Fears (-13% in 2015)
Through all of this mayhem, including the current 2016 dip, the stock market has still managed to rise an impressive +77% since the 2011 pullback, which sure beats the sub-1% yield earned on bank CDs.
Inevitably, with the recent price breakdown, speculation has begun to swirl around the dreaded “R”-word (aka, recession) again. In general, this is a fruitless effort. When the smartest Nobel Prize winning economists fail miserably at predicting recessions, it’s hard to believe you or I will have a much better success rate. The great investor Peter Lynch astutely summed up recession forecasting as follows:
“It’s lovely to know when there’s recession. I don’t remember anybody predicting 1982 we’re going to have 14 percent inflation, 12 percent unemployment, a 20 percent prime rate, you know, the worst recession since the Depression. I don’t remember any of that being predicted. It just happened. It was there. It was ugly. And I don’t remember anybody telling me about it. So I don’t worry about any of that stuff. I’ve always said if you spend 13 minutes a year on economics, you’ve wasted 10 minutes.”
The noted Nobel Prize winning economist Paul Samuelson offered this shrewd observation on recessions as well:
“The stock market has called nine of the last five recessions.”
In other words, the stock market can predict recessions, but often times it is a horrible indicator for the health of the economy (e.g., see 2011-2015 above).
While I am definitely not a Nobel Prize winning economist, I can objectively point to supporting evidence showing we currently are not on the edge of a new recession. It is certainly true that a strong U.S. dollar and a Q4 energy earnings deterioration has been a drag on earnings, but these factors only paint a small part of the picture. Without going into gory economic detail, you do not need to be an expert to understand basic macro trends like employment, housing, auto sales, gasoline prices, and interest rates are providing a buttress to the economy.
As you can see from the chart below, the -73% cut in Q4 energy sector earnings, along with challenged exports from multinational corporations, has pressured profitability in the S&P 500. However, if you strip out the energy sector, earnings continue to grow. And although it’s early in the 2016 earnings reporting season, so far 73% of companies are beating estimates by 3% on average.
The economic winds are definitely spinning, and we may not be completely through the turbulence, but rather than panicking, you’re probably best served by following the advice of Jack Bogle by standing through the turmoil and look for opportunities when the volatility settles.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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