The following post is extracted from my January 2016 newsletter to clients.
Market Summary For 2015.
The Theme For 2016? Volatility.
Most major markets finished the year 2015 lower than they started, in spite of new highs a few months earlier. The Dow Jones Global Index - representing 95% of global market capitalisation across 48 countries - fell 4% in the year. Whilst in USA the S&P 500 dipped by only 0.7%, internationally the MSCI World Ex-USA index - covering 22 of 23 developed markets (excluding USA) - fell by 5.4%. The UK’s FTSE 100 fell almost 5%.
Whilst the Eurozone benchmark EURO STOXX 50 was up 3.8% and the broader STOXX Europe 600 up 6.8%, these indices are both valued in Euro, which fell 10% against the USD in 2015.
In Japan the Nikkei 225 rose a solid 9%, with the Yen holding steady against the USD during 2015, after two previous years of significant devaluation. However elsewhere in developed Asia-Pacific the Australian ASX200 dipped 2% against a backdrop of AUD falling almost 11% versus the USD. In Singapore the Straits Times index fell 14% during 2015, with the currency SGD losing 6.5% against the USD. Hong Kong suffered also with the benchmark HSI down over 19% (the currency HKD is pegged to the USD).
In China, 2015 saw the Shanghai SE Composite Index rise from 3234 to a peak of 5166 (60% rise) in June, only to plummet to 3038 by September (a 41% fall in four months) before recovering to end the year at 3539, technically a gain of about 9% for the year but on the back of extreme volatility.
Elsewhere other emerging markets were pummelled, with the broad MSCI Emerging Markets Index down 17% for the year. Latin America continued a multi-year downward trend and the Dow Jones Latin America index sunk a further 32%. In comparison, India’s BSE Sensex 30 drop of 5% in 2015 seems almost trivial.
Precious metals have offered no safe haven, with the Gold spot price falling 10% during the year from 1183 to 1060 USD/oz., well below average production cost, and the mining industry consequently amplifying loses further - the NYSE ARCA Gold Miners Index fell by 25% breaking downwards below 2008 levels during the global financial crisis.
The Oil & Gas industry has similarly suffered with the NYSE ARCA Oil Industry benchmark continuing downwards by 20% in 2015, as the price of oil crashed by 35% to end the year around $37.28 per barrel.
Winners have been hard to spot for 2015. Some performing sectors have included Consumer Services, and Technology - underlying the modest 5.7% growth in the NASDAQ Composite, a naturally technology biased index.
Start of 2016 marked by global economic uncertainty
Over the holiday break, a friend sent my wife a Facebook video taken from a dashboard cam. It was a rural road in Thailand and the truck in front was piled incredibly high with crates of some kind. The truck wasn’t moving particularly fast, but the driving was very erratic. The truck was wobbling all over the road and the rear of the vehicle was swinging from side to side, over the curb at one point and over the central line a few moments later. This seemed to go on for a while, but then the whole thing flipped sideways and down the roadside embankment. (Luckily it seemed that nobody was hurt.)
What made the video so compelling to watch was the element of suspense… you really didn’t know whether the driver would be able to bring the vehicle back under control. But when the truck did finally tip over, it was certainly not a surprise.
Market volatility is the same. It doesn’t necessarily predict what comes next, but if volatility is moving upwards we shouldn’t be surprised when something bad happens.
The VIX ‘fear gauge’
The VIX is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days, quoted as an annualized standard deviation. The VIX was launched in 1993, originally representing the implied volatility in the S&P 100 by reverse engineering the options pricing formula for at-the-money options. The calculation method was updated in September 2003 to cover a broader range of option strikes on the S&P500. It was updated again in October 2014 to use blended weekly S&P 500 options rather than monthly, hence improving accuracy on the 30-day measure.
Referring to the chart below:
- Top panel: shaded area is the S&P 500. The black line is the ‘slope’ calculated by linear regression on the last twenty data points (monthly closing price).
- Centre panel: shaded area is the VIX (monthly data). Blue and red lines are twenty and fifty period moving averages respectively.
- Bottom panel: MACD on the VIX.
As we start 2016, the VIX is trending in a startling similar way to 2007 prior to the global financial crisis. The underlying average rise of the VIX during 2015 is clear, and accelerating. Moreover, the S&P 500 slope line is approaching zero, and has crossed below zero only twice in the last two decades - once in 2001, early in the dot-com bust, and once in 2008 just before the crisis.
What about the economists forecasts?
A forecast for the economy is supposed to give us some clues as to markets future behaviour. So of course it makes sense to pay attention when those who are qualified express an opinion. The IMF. The World Bank. Central banking officials. Etc. But there are always disconnects and lags between the economy and financial markets. For example, China’s current economic woes are in large part due to the transition from a manufacturing and export led economy to a domestic consumer and services driven economy. This is all good news for China in a few years’ time, but right now markets show that short-termism prevails. It’s a matter of timing, and successful long-term investors know the best time to buy is when assets are out of favour.
Another problem is that mainstream economists find it difficult to forecast a recession - even the biggest recession of modern times, the 2008 global financial crisis. The European Commission’s forecast for the Eurozone in 2008 was growth of 2%. The IMF’s 2008 forecasts were 2.5% for the Eurozone and 1.9% for the US. The Federal Reserve governors were going for 1.3%-2% for the US, and that forecast was in January 2008. In fact, by Q3-2008 US growth was below -4% and the Euro area was -5.5%.
So, if by some chance we were approaching another economic cliff-edge, I wonder how likely it is that we’d hear about it first from such sources?
Currencies are important
Currencies seem poised to play an even greater role in 2016 than last year. With rising US interest rates, debt repayments become more significant for US corporations, and corporate bonds become more expensive to issue. This impacts profitability, price-earnings ratios, and hence valuations of US companies.
Overseas in Asia-Pacific and emerging markets, cheap dollar loans have been a fuel for growth. But now repayments will become more expensive in interest rate terms. Furthermore, as US interest rates rise the dollar will strengthen, and overseas firms are hit by a double-whammy - if your revenues are in a currency that falls against the US dollar, it’s going to get tougher to repay banks and bondholders.
As I write, China is working hard to support its currency, which is today at it’s weakest for five years. But some analysts expect a 4%-5% devalution in the CNY against USD during 2016. If that happens, then quite possibly other countries in the region will also allow their currencies to fall, to maintain competitiveness. USA exports will suffer, and at the same time corporate defaults overseas will increase. This is all economist-speak of course. We don’t know what will happen.
The trend is your friend
Investor irrationality and herd behaviour makes markets move up and down erratically in the short term, superimposed over the longer term trend. If there is an underlying trend at any particular time, it would certainly be useful to know about it. The problem is, by definition, long term trends take time to become visible, and confirming a turning point can be only be done in the rear view mirror. The chart below shows the S&P 500 (monthly data) and some momentum indicators - there are some similarities between now, and both the dot-com bust and the global financial crisis. The stochastic oscillator has crossed below the 50 line only those two times in two decades. If it crosses in the next few months, that’s a potential forewarning of further major drops in the S&P 500.
Implications for investment strategy
As a reminder, your strategic (longer term) asset allocation is the basic split between key asset classes in your portfolio. For example if you have a long time horizon and are a very adventurous investor, then maybe you want 20-25% bond holdings, 20-25% core equity, and the rest focused on Asia-Pacific, emerging markets and some specialist sector investments. On the other hand, if you are approaching retirement and are naturally cautious, you would sleep better at night with perhaps a 60-70% bond allocation, and the rest focused on developed market equity.
In the long run, markets go up. But there’s no harm to check that our asset allocation is tactically aligned to our best guess about nearer-term market prospects.
Lump sum investments - just like with that erratically driven truck recorded on dash-cam, we’re in suspense about what happens next. It makes sense to check our safety belt is fastened. If you are a cautious investor or have a short-medium term time horizon, tactically adjusting your portfolio for more ‘risk off’ might be worth considering over coming weeks. More government and investment grade bonds. Less exposure to non-core equity markets.
Regular savings plans - dollar cost averaging is no myth. As prices go down, by drip feeding money monthly into the markets we are ‘buying in’ to the market bottom. When the recovery comes and prices rise, ultimately we amplify gains because our average purchase price is always lower than the market. Even if the market simply recovers back to the same level it was when we started regular investments, we are guaranteed to have made a profit. In the early years of a long term savings plan, we want volatility. We want prices to head south and stay low for a nice long time to give us a chance to hoover up assets at discount prices.