Market Volatility: Don’t Panic… Just Yet by Worth Wray, Tyler Hay, and David Hay of Evergreen GaveKal
“The psychological effect of stock market activities on business is, I think, overemphasized…I do not think that the fall in security prices will itself cause any great curtailment in consumption.”
– E. H. H. Simmons, president of the NY Stock Exchange, January 26th, 1930.
THE EVERGREEN EXCHANGE
Worth Wray, Tyler Hay, David Hay
What a difference a month makes! Realizing that the suddenly vulnerable US stock market is top of mind for most investors, three of our team-members are going to explore several possible scenarios in this month’s edition of the Evergreen Exchange. We are attempting this with full admission that we are looking through a glass darkly as all investment professionals are these days. We also concede there are definitely more than three possible paths for stocks to take in the coming quarters. As noted repeatedly in prior EVAs, there truly is no precedent or playbook for how this era of extreme central bank manipulation of asset prices will end. But we are convinced that when it does, it is likely to be messy—possibly very, very messy. Yet, times of chaos, uncertainty, and fear typically bring exceptional opportunities for cash-heavy investors with a willingness to buy into the panic.
While we are taking different tacks and coming to varying conclusions about the longer-term outlook, you might notice that all three of us believe an oversold rally is a near certainty (and we felt that way even before this week’s bounce happened). We also suspect it will be relatively brief. In our view, a more durable recovery will not occur until prices decline meaningfully and valuations return to more reasonable levels.
Now, without further ado, let’s check out the three scenarios.
DON’T PANIC… JUST YET
Scenario #1: Correction likely overdone as global investors overreacted to previously under-appreciated China risks and herding behavior took over. A rally here is an opportunity to get defensive. New highs are possible as inflows from abroad drive P/E multiples higher, but beware shocks from abroad.
As my colleagues and I have continued to warn in recent weeks, anxiety from China and fragile emerging markets is starting to spill over into major developed markets around the world. While the direct economic linkages are admittedly limited—especially in the United States, where exports account for a modest 13% of GDP—what we have seen in recent days is proof that our interconnected and dangerously leveraged global financial system is subject to extreme herding behavior. All it takes is a break in the prevailing mindset to trigger a global rush for the exits.
As you can see in the charts below, US equity volatility, as measured by the VIX Index, jumped from 12 to 47 on Monday morning as a number of high-quality stocks and relatively high-volume ETFs sold off in classic flash-crash fashion. We saw credit spreads blow out, commodities and emerging market currencies slide to new lows, and equities drop in an outright panic. While a number of traders had speculated that Monday could be a rough day for global markets, no one could have guessed that the week-over-week change in the VIX would explode to levels unseen even during extreme events like the Lehman shock or the Euro crisis. This is what a mild panic looks like in a market dominated by high-frequency trading, ETFs, and systematic allocation models.
FIGURE 1: US EQUITY VOLATILITY (VIX INDEX)
Source: Evergreen GaveKal, Bloomberg
FIGURE 2: US EQUITY (VIX INDEX) ONE-WEEK CHANGE
Source: Evergreen GaveKal, Bloomberg
Through Thursday (8/27), the S&P 500 has fallen 6.5% from its May 2015 peak, which begs a critical question for US investors: Are we on the edge of the great unraveling? Is this sell-off the beginning of a vicious bear market? Or are we just experiencing a long-overdue correction—the first in four years—in an otherwise durable rally?
In my mind, a major break seems a bit premature. And the sudden shift in market sentiment appears to be overdone. I won’t go so far as to call this correction a long-term buying opportunity, but I also wouldn’t abandon the safety of a defensively-positioned, diversified portfolio to make an all-in bet on cash or US Treasuries. Unless the US economy suddenly slides into recession, this bull market can run a while longer and valuations can stretch even further against a backdrop of weakening global growth… which would raise the uncomfortable odds of a major deflationary accident in the medium term.
Consider, for a moment, why global financial markets are melting down. While emerging markets like Brazil, Russia, Turkey, South Africa, Malaysia, and Indonesia (among many others) have been deteriorating for several years, and capital outflows have certainly accelerated in anticipation of a Fed rate hike over the past several months, the US dollar has not fared favorably in the past week. In fact, we saw both the euro and the Japanese yen surge against the dollar on Monday morning as markets took the turmoil as a sign the Fed would be forced to delay a hike. More on that in a minute, but suffice to say that the US dollar is not driving this correction. China is… or rather the market’s over-reaction to recent events in China.
Let me be clear. China is not collapsing, but Beijing’s credibility is. Last month’s confidence-killing intervention in its domestic equity market, coupled with growing capital outflows, the clumsy move to a more market-oriented exchange rate, and the recent drop in China’s manufacturing Purchasing Managers Index (PMI), has led to a sharp break in a broadly-accepted narrative. The world is suddenly realizing that Chinese economic growth is slowing more dramatically than the official numbers suggest and Beijing may be losing control. But while the simultaneous un-anchoring of what had been one of the world’s most stable currencies—and widespread questioning of what had been one of the world’s most credible governments—is understandably having a big impact on sentiment, the direct economic impacts are not so sudden.
A number of China watchers—myself included—have been warning for years that economic growth was slowing dramatically under a weight of bad debt incurred in the wake of the Global Financial Crisis. We shouted from the rooftops that China’s growth was far too reliant on credit-fueled, malinvestments in “old economy” sectors (like real estate, infrastructure, mining, and low-value-added manufacturing). We said that the Middle Kingdom faced an epic crisis or long-term stagnation if it failed to quickly transition to a more sustainable growth model driven by “new economy” sectors (like retail, services, technology, and high-value-added manufacturing). We even warned that an avoidable crisis in China could send a shock wave through the global financial system and that the inevitable investment slowdown would be enough to destabilize commodity-oriented economies around the world.
That said, it’s important to note that we are not seeing an economic crisis in China today. The world is waking up to the under-appreciated risks in the People’s Republic because its equity market is collapsing. And while a crashing equity market dramatically increases the odds that China will find itself stuck in the middle-income trap,