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:
- 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.
- Earnings are surprising to the upside: 73% of firms that have reported results have beaten second-quarter earnings, which is in line with the 5-year average. The blended earnings growth rate for the entire S&P 500 has been revised higher since June 30th estimates.2
- Improving economic growth: Economists expect second-quarter US GDP to be revised higher, from 2.3% to 3.2%.3 A strengthening labor market combined with continued growth in household formation and consumer spending are driving the upward revision estimates.
Global growth was the market’s concern this past week. However, US data is improving and the Eurozone is showing promise, with Germany leading strong manufacturing reports. Continued accommodative monetary policies throughout the Eurozone and Japan should also support growth in those regions.
How to position for market turbulence
This stock market correction presents an opportunity for investors to reassess their holdings and portfolio construction strategy. When the dust settles, we believe that we’ll likely see the market return to an environment where growth-oriented segments do well as investors seek out opportunities in a macro-driven world.
This market volatility underscores the importance of portfolio construction and it reminds us of these guiding principles:
- Harry was right: Harry Markowitz, the author of modern portfolio theory, famously said diversification is the only free lunch. In times like these, investors are well served to remember this advice and ensure portfolios are diversified across a broad range of asset classes—from equity and fixed income to real assets, such as the tail risk protection that Gold, which has rallied more than 4% in the last week, can offer.
- Don’t do it alone: Investors who pick single stocks to play market themes may find themselves feeling exposed and might want to consider sector investing instead. If we examine the holdings of the Energy Select Sector Index on Monday, the worst performer in the index was down 10.35%. Meanwhile, the average stock was down 5.47% and the Index dropped 5.23%.4 That means that if you chose the wrong individual stock, you would have been off 5% from the benchmark. Sectors and Industries can provide the diversification that’s needed when the market presents thematic opportunities.
- Fixed income portfolios need balance: The Barclays U.S. Aggregate Index was up on Monday as Treasuries rallied. While the long end of the curve rallied the most, long term Treasuries only account for 5% of the Agg—illustrating how the Agg’s exposure offers a narrow slice of the bond market.Credit suffered as risky assets faced headwinds, but the Agg’s exposure may not be optimal for investors who are looking to have the full breadth of fixed income in their portfolios. For investors who want to balance credit and interest rate risk, it might be time to consider barbell strategies to help navigate today’s market.
As markets continue to gyrate, investors should take the time to reevaluate their methods of portfolio construction, and ensure that they remain sufficient to meet client risk profiles and long-term goals.
1As represented by the Bloomberg Commodity Index. Source: Bloomberg, SSGA, as of 8/24/2015
2FactSet, as of 8/24/2015
3Bloomberg Economic Forecasts, as of 8/24/2015
4Bloomberg, as of 8/25/2015
David Mazza is a Vice President of State Street Global Advisors and the Head of Research for SSGA’s ETF and mutual fund businesses.