August has ended on a volatile note, as the final full week of the month saw a dramatic increase in volatility. The Dow posted a loss of 6.6% in August, its largest decline since May of 2010. The S&P 500 posted its worst monthly decline since May of 2012. Stocks in Europe fell 8.5% in August, the Shanghai Composite fell 12.5%. In this brief update, we dive into some analysis of last week’s market, then examine historical stock market corrections, and finally offer some thoughts about the economy and markets over the next six months.
Why did the stock market decline last week?
Last week’s quick decline in stocks was blamed on numerous issues:
Since the beginning of 2015, companies have experienced a multi-month decline in earnings expectations. This has undoubtedly led to investor nervousness about the health of the global economy.
Similarly, the global economy has experienced some general slowing during the past few months. This has been most evident in commodities weakness, Emerging Market stock market declines and has fed fears of deflation.
Since the spring, the interest rate demanded by investors to buy junk bonds has increased slightly. This can be a sign of worse things to come, but the changes have been generally mild and gradual.
China’s unexpected devaluation in late August added to uncertainty about its overall economy. Weaker expectations around China have made investors jittery.
Much attention has been focused on when the Federal Reserve will begin raising interest rates. Uncertainty around the Fed’s tightening policy also likely contributed to stock market volatility.
Technical deterioration inside the market and low volume in August also set the market up for a potential near-term correction.
As the chart above shows, the VIX—which measures the volatility of the stock market through options pricing, was up 100% from its recent low. The spike in such a short span was a record-breaker. The VIX is a good measure of investor fear. Last week, fear went from fairly low to full-blown panic; and there were complicated knock-on effects throughout the US equity market, through derivatives, positioning, and the strategies market participants use to manage the risk. The gyrations last week went well beyond the change in the fundamentals.
So What Happens Now?
A recent study of corrections by Dr. Brian Jacobsen on S&P 500 data going back to 1949 reveals some interesting figures:
By way of definition, a bear market is a move of 20% or more from the top to the bottom (peak-to-trough) and a correction is a move of 10% to 20%.
The average bear market drop is 31.6% and most bear markets have been associated with significant economic downturns.
The average correction is 13.4% and takes 108 days to move from the market high point to its low point.
After the correction, the average stock market gain is 47.0% and this gain takes 495 days, on average, to attain.
Another study, by Barclay’s Research, analyzed the S&P 500 after rapid 10% declines. The table below summarizes the results of this study:
Last week, the S&P 500 fell more than 10% in only four trading days. Since 1940, there were 10 other times when stocks fell at least 10% in just four days. After such a rapid decline, the market often struggled in the near-term, but was positive 9 out of 10 times after 250 trading days. In most cases, it was substantially higher. The only negative was at the beginning of World War II.
Finally, a study by Bespoke Investment Group is worth mentioning. Last week, the financial press touted the “death cross” of the S&P 500. This technical indicator garnered enormous attention on MSNBC. These crosses occur when the index sees its 50-day moving average cross below its 200-day moving average as both moving averages are declining themselves. There have only been 10 “death crosses” in the history of the S&P 500, since 1928. The table below summarizes the findings of this study.
As you can see, performance in the month following the “death cross” is choppy. Yet over the following three and six months, the index has climbed significantly. The only time that the index was lower was in the six months following the October 2000 period, at the height of the tech bubble. The takeaway from this study is that, on average, the market climbs 8.2% in the following six months after a “death cross”. In fact, the market is positive 90% of the time after six months.
Since 1928, the US has experienced 23 bear markets, yet only 3 of them did not occur at a time either immediately preceding or during a recession. Bloomberg’s recession probability model predicted the chance of a recession in the US during the next 3 months is only 12%. In other words, there is an 88% chance that we will continue economic growth over that same period.
How is the economy doing?
The US economy is, broadly speaking, relatively healthy. We continue to believe that, absent any significant shock, the US economy will grow at 2% per year for the next several years. While 2% is not a stellar growth rate, it is certainly not recessionary. Unemployment has steadily declined in the past several years. Manufacturing surveys have been expansionary in 71 of the last 73 months. The bond market yield curve is positive for growth. Housing starts are strong and central bankers around the world—specifically Europe, Japan, and China—continue to enact quantitative easing programs.
Last week saw a surprise upgrade in US GDP from 2.3% real to 3.7% real growth. All five categories of the GDP measurement were strong: Consumer spending, government spending, trade, non-residential investment, and residential investment. The table below, courtesy of Bespoke Investment Group, shows that most of the economic data last week was positive:
Some analysts are pointing to the collapse in oil prices as a harbinger of economic recession. Yet falling oil prices have never correctly forecasted a recession. The independent analysis firm GaveKalDragonomics notes that on every recent occasion when the price of oil is halved—1982-83, 1985-86, 1992-93, 1997-98, and 2001-2002—faster global growth followed. Conversely, every global recession in the past 50 years has been preceded by a sharp increase in oil prices.
We believe the US will continue to see positive—albeit weak—economic expansion. The triggers of previous recessions do not seem to be present today: Accelerating inflation in the ‘70’s, the Savings and Loan crisis of the late 1980’s, the tech bubble of the late 1990’s, or the housing bubble of the 2000’s.
Concluding Thoughts:
Given the data in front of us right now, we believe that the US economy will continue on its path of slow growth over the next 3 to 6 months. During a correction, markets often re-test their lows before moving on to higher levels. With the studies mentioned above in mind, we believe the most likely course of the US stock market is going to be volatile and choppy over the next several months, but positive through the winter and spring. While we do not see signs of widespread economic deterioration, the ripple effects of China’s economic situation are difficult to calculate and next year’s presidential election in the US could portend a difficult summer in 2016.
