October 21st, 2015 | Miller Advisors

Turn off the noise: are we back to “normal” volatility?

What happened last quarter?

June 12, 2015 marked the beginning of a significant correction in China’s stock market which spanned most of the summer months. Despite several attempts by the Chinese government to halt the sell-off, the Shanghai Composite Index lost nearly 43%, peak-to-trough. Roughly two months later, on August 17, the Dow Jones Industrial Average embarked on a more muted correction, losing 10% over the course of seven consecutive trade days.

Further, complicating matters for China, government officials made a surprising move by defaulting the yuan, China’s national currency. Chief Economist Scott Brown, PH.D explains the failed experiment: “They were not trying to boost exports by weakening their currency. What they were trying to do was move towards a free-floating currency—to have a market-based determination of the exchange rate.” What was actually an attempt to implement positive structural reform quickly turned into a misinterpreted signal by investors that further economic slowdown was to be expected.

Where are we now?

The Shanghai Composite Index continues to display height-ended volatility, yet remains up around 30% over the last year, as of late-September. Brown makes an important point, noting that, “China’s stock market decline is not really indicative of economic weakness, nor is it necessarily going to cause economic weaknesses. That said, Chinese growth has slowed.” European strategist Chris Bailey opines that, “President Xi of China is actually making pretty good progress on its structural reform.” Furthermore, Bailey finds the likelihood of successful reform much greater for China than for Europe.

U.S. equity markets have since followed suit, with the Dow Jones Industrial Average recovering from late-August lows, but volatility remains elevated. General consensus believes that recent U.S. market activity, while unpleasant, is a healthy correction and normal party of the equity market cycle. Still, it can be alarming for those who don’t understand the phenomenon of a correction. Any sustained period of price appreciation, as seen in China as stocks began skyrocketing in mid-2014, is a warning to many astute investors attempting to take advantage of inflated asset prices rather than trading on fundamentals. Eventually, the “bubble bursts,” removing speculators from the market and paving the way for a return to a “normal” investment environment.

Turbulent markets following a quiet period of general price appreciation with low interest rates can be troublesome for investors who have become complacent with the current environment. In turn, they may have overextended their portfolio’s risk profile in an attempt to stretch for yield or increase total return. Director of Mutual Funds Research & Marketing Peter Greenberger reminds us that it is in moments like this that Warren Buffet’s investment acumen holds true: “Only when the tide goes out do you discover who’s been swimming naked.”

Where are we headed?
So what does this say about the future state of the equity markets? Chief Investment Strategist Jeff Saut reiterated his long-term bullish stance, stating, “To a long-term bull, which is what I am, what happened over the last several weeks is just noise. Our belief is that this is a pull-back in an ongoing secular bull market that still has another eight or nine years left to run, providing the averages don’t cost below August 25 lows of 15,666 on the Dow and 7,466 on the Dow Transportation Index.”

Managing Director of Equity Portfolio & Technical Strategy Michael Gibbs agreed that this was an ordinary correction, pointing out that it takes time for markets to settle after a significant loss. “During this period, over the next three-six-nine months possibly, the markets have the potential to be more volatile as investors wait and try to get clarity on what is really happening around the world.” He is confident that as time plays out, “Everything will be fine with economic growth. The global economy is still set to grow at 2-3%, as is the U.S. economy, and typically you do not see a bear market in stocks when the economy is growing.” Brown concurs, assuring that “despite all of this noise, underlying it all is a domestic outlook from the U.S. which is still very, very promising.

As Gibbs emphasized, “The one thing that investors despise is uncertainty.” Given that the short-term market outlook is unclear—as policies unfold at home and abroad—now is an opportune time to reevaluate current portfolio positioning. In particular, comparing the current risk profile of the portfolio to that of the investor’s risk tolerance can identify mismatches that require repositioning. Whether it’s pairing back or mitigating current risk levels, participating in in the glut of buying opportunities available in oversold markets, or simply staying on track; managing expectations surrounding risk/return objectives is central to reducing investor surprise, panic, and emotional decision-making during volatile market environments.

Source: Kristin Byrnes, Raymond James | Image: Getty