Market Decline is an Overreaction–Better Days Ahead

Carson Cole, January 20, 2016

Markets have been on a sharp decline this year, with today adding incremental losses that bring the Dow Jones Industrial average down 9.5% this, the S&P down 8.8%, and the Russell 2000 down 11.5%. It has been a rough year.

It has been extremely hard to hide unless you’ve held cash. Not only are stocks down, but interest rates have risen with spreads on corporate bonds widening to levels not seen in a number of years. Oil has fallen around 30%, along with most other commodities, and is now at a level last seen in December 2001.

The only bright spots include U.S. Treasury 6-month bills and bonds, which have seen their yields decline on average by 25 basis points (with their prices rising). Over the last five years, rates have declined so investors in Treasury bonds have done well. The other has been gold, which is up 4%, however it has not performed well over the last 4 years in total, with gold at around $1,060, down 38% from $1,722 in 2011.

The headline culprits for the market decline are many–sovereign wealth funds, algorithmic traders, declining oil prices, slowing China growth and looming recessions ahead for the U.S. and global economies amongst other reasons.

This market rout has likely mostly been driven by a change in expectations. We see this in how the market (S&P500) has lost over $2 trillion in value since January 1, yet the economy has been very strong and shows little weakness. Housing demand remains robust, employment overall is rising, and the consumer has not been in a better position in the last ten years.

Expectations may be adjusting to fears over China, where we believe the severity of a slowdown in China are overblown. Growth is slowing, but still leads in the world at an impressive rate officially of 6.9% in 2015, down from 7.3% in 2014. The middle class is growing at an incredible rate, the country remains the manufacturing powerhouse of the world, and it benefits from the declines in commodity prices we have seen in oil and other commodities that fuel its economic engine.

Changing expectations seem to be whipsawing the market, which we think are being precipitated by: 1) Electronic algorithmic trading, and 2) the removal of the uptick-rule. Algorithmic trading sells on market swings, whether up or down, and we’ve had more down days in recent history than up. As a result, market movements are magnified. Take today for example, where the market fell 565 points at its low, but then rallied to close at only down 246 points, all on no apparent new information.

The removal of the uptick-rule in 2008, in our opinion, has allowed for increased pressure on markets on the downside. The uptick rule forbade short-selling (the sale of borrowed, not owned, stock, which ultimately have to be repurchased) of stock when the previous trade occurs on a down-tick.

Markets are trading down and it is a classic overreaction. There are many factors weighing on the conscience of the market, but as time passes, these current factors will diminish in significance. Earnings are solid, particularly for the companies in which we are invested. There will be better days. We are down now, but we will look back and see this as a great opportunity as the market will rebound. Investing in the S&P 500 in 2008 would see your portfolio up over 165% today. It is times like these we should stay or become more invested. Not the reverse.