It’s pretty easy to get your hands on financial market commentary these days, between newspapers, websites, podcasts, tip sheets, broker reports and even dedicated financial TV channels. The thing is most of them focus on the story of the day: they’re like a windsock showing which way the wind is blowing at the time. When it comes to explaining why global financial markets have corrected heavily in the past six months, so far they’ve attributed it to oil prices, Chinese growth, recession fears in the U.S., rising U.S. dollar, the falling Chinese renminbi, declining earnings, monetary policy excesses. So what is really driving markets?
Bear markets are usually attributable to some kind of catalyst, there is normally something pretty definite to point your finger at, but this time it’s not so clear. That’s not to say there’s no reason, it’s just more that it looks like there’s a bunch of them all working together. Let’s look at some candidates.
Some equities markets peaked around April/May last year:
But the S&P500 really fell out of bed in August 2015, having gone sideways for quite a while.
So what happened back then? Was it the oil price? Interestingly, around the time the Australian and U.K. markets started to fall oil was in the middle of an almost 50% rally, which peaked on 23 June. It then fell 40%, finishing that downward leg on 24 August. Also interestingly, the S&P500 fell 11% between 17-25 August – perhaps no coincidence?
Then again, oil had suffered a big tumble before that, falling 58% between June 2014 and January 2015, during which time the S&P500 went up 6%:
When oil finished that first (precipitous) leg down in January 2015 I don’t recall any talk of credit defaults or EM problems, so it’d be kind of surprising if that was behind the equities markets deciding to start tumbling.
Tellingly, the correlation between oil and equities has now spiked to almost 1, meaning the prices move up and down in lock step (-1 means they go in the exact opposite direction to one another):
Correlation between the S&P 500 and Brent crude Oil, monthly
But then two points: first, back in August the correlation was about 0.6, so why did the equities market start to fall? Secondly, does that number really tell us anything? I mean, isn’t it part chicken and egg (is oil following equities or the other way around?) and part ‘correlation doesn’t equal causation’?
Does U.S. GDP give us a hint? It peaked at 2.7% in the March quarter of last year and then started heading downwards:
Whilst that would be very convenient, a couple of points to remember: GDP data doesn’t get reported until the month after the period to which it refers, so the fact that the June quarter was lower than March wasn’t reported until 30 July. So the timing doesn’t account for non-U.S. markets and the S&P didn’t really start falling until two weeks later – why would there have been a delayed response? Also, believe it or not, the long-term correlation between GDP and the stock market is zero – they bear no relation to one another.
How about Earnings Per Share, after all, that’s what you’re buying at the end of the day. According to the chart nelow earnings started to drop off a good 12 months before the S&P500 started its nasty correction.
Was it Chinese growth? Admittedly Chinese economic statistics are probably not the most reliable, but for what it’s worth the GDP data didn’t look disastrous at the time; definitely a downward trend but no gapping down to cause such a big hissy fit surely:
Also, U.S. exports to China account for less than 1% of GDP. On that basis China’s manufacturing data barely affects the U.S.
Was it the rising U.S.$?
The U.S.$ started rising sharply around July 2014, a full year before the S&P500’s correction.
Now here’s a genuine looking culprit for triggering a selloff: the Chinese currency devaluation, the first leg of which took place on Monday 10 August 2015. The S&P’s correction started 17 August – a bit odd they waited a week if this was the catalyst, but it’s the closest thing so far.
So why would that be such a cause of concern for the S&P500? Frankly, I’ve no idea. According to JP Morgan however, the initial reaction to the August renminbi devaluation set off a string of stop losses, that is the market fell through a specific level that forced traders to sell even more and so setting off a chain reaction. They claim the end result was a whole lot more about that than China.
Final attempt: there has been a huge correction in credit markets. Hopefully you’ve been reading our blog articles which talked about this, but the commodities selloff sparked concern that a bunch of companies that had borrowed money either on the bond or loans markets would struggle to meet repayments. That of course increases the likelihood of default, which causes the spreads to blow out, i.e. the margin of safety demanded by lenders to those companies. This is also reflected in the Credit Default Spreads, which are like insurance policies that you can buy that pay out if a company defaults on a loan. The higher the price of the insurance, the more the market thinks the company is going to default. The chart below measures CDS costs in Australia, but the picture is the same offshore as well.
The problem is, once again the timing doesn’t really match up.
The bottom line then is that it’s really hard to find a single reason to hang your hat on as to why financial markets have been so weak over the past six months. It really does look like there’s a bunch of factors working together, and when there are so many moving parts, you’re never going to know when things have bottomed out.
Which brings me back to our standard response: we can’t tell you when markets will bottom (and neither can just about anybody else), but we can tell you if we think there’s value. Here are the most recent tipping point tables from our asset allocation consultant with current levels marked in and showing the projected 10 year annualised returns.
When markets are projected to return better than 10% p.a. compared with a risk free investment returning about 3%, it tells you there is value there.