How to Construct Portfolios Amid a Stock Market Correction | ETF Trends

The violent market sell-off we witnessed marks the first time in 46 months that US stocks have entered into correction territory. It demonstrates how interconnected markets have become, linked to such an extent that worries over an economic slowdown in China can have the power to spark a market rout around the globe.

This aggressive broad-based selling is not necessarily a precursor to a recessionary environment as economic data and positive earnings revisions continue to point toward a strengthening US economy and lend a supportive backdrop for risk assets. But the stock market correction does remind investors that volatility can emerge from any corner of the world, and it underscores the importance of building portfolios that can weather unexpected turbulence.

What triggered the sell-off?

In my opinion, the cause of this sell-off can be largely be attributed to the significant turmoil in China’s stock market, which prompted the People’s Bank of China to announce a surprise devaluation of the yuan earlier this month. China’s actions exacerbated the existing economic malaise in commodity-rich emerging markets, as a 30% drop in commodity prices has weighed on their growth trajectory.1 Further currency devaluations and accommodative monetary policies were enacted by other emerging marketing nations to combat the slowdown and make their exports similarly attractive.

These events prompted fears of a potential spillover into the developed world, turning sentiment overwhelmingly negative leading up to the close of world markets last week. In the US, this potential for a spillover effect spooked investors who worried that these events would further dampen the US’ ability to see true economic liftoff, as the Federal Reserve has been signaling a desire to decouple monetary policy from the rest of the world.

The disconnect between the sell-off and fundamentals

While reading headlines filled with talk of a stock market correction may be scary, the aggressive selling we’ve witnessed is not consistent with fundamentals pointing to an ongoing US economic recovery. Here’s why:

  1. Sentiment has swung too negative: The selling appears overdone and I believe it should snap back based on historical trends, as depicted in the “Bloomberg NYSE New 52 Week Highs Minus Lows Index” chart below, which shows that the index has dropped two standard deviations below its average. Over the last five years when this occurred the duration of time spent below the pivotal 2 standard deviation event has been a matter of days.
    Source: Bloomberg, State Street Global Advisors, as of 8/21/2015. Past performance is not a guarantee of future results.