How 3rd
Quarter of 2015 Market Corrections Compare to the Common Cold
Have you ever caught
a cold that seemed to drag on forever?
The kind of cold where your sniffles and coughs persist for weeks?
The markets are
experiencing just such a cold now.
The third quarter has
ended, and no one is sorry to see it go.
In fact, it was the worst quarter for stocks since 2011, with both the
Dow® and the S&P 500® down 10% or more at some
point. This is what’s known as a “market
correction”—a 10% drop from a recent peak.
Like a cold, a
correction is never pleasant. And like a
cold, a correction can drag on for a long time.
But that doesn’t mean it has to be scary, or that we have to overreact to
it. If we try to understand it instead, we might be able to fight some of the
symptoms along the way.
No cure for the common correction
Even though we can
put a man on the moon or find water on Mars, we still don’t have a cure for the
common cold. That’s because there are
simply too many viruses that cause colds, each with different strains,
mutations, and variations.
The same is true of
corrections. There’s simply no way to
prevent a correction from happening,
because the root causes are too many, too varied, and too complex.
Actually, you could
make the case that both colds and corrections are good things. After all, if we never got sick from the
every-day sort of germs, we’d never develop antibodies, rendering ourselves
defenseless against the truly nasty bugs out there. Similarly, market corrections help bubbles
from forming. For example, if stock
prices kept going up and up, far above the value of the actual companies behind
them, people will eventually realize they are paying too much money for
something that simply isn’t worth it.
That’s a bubble … and like all bubbles, it will eventually pop. The resulting crash is often far worse than a
mere market correction. (This is exactly
what’s happened to China, as we’ll discuss on the next page.)
Furthermore, market
corrections can even be useful for investors, because they create opportunities
to buy good companies at lower-than-normal prices.
If you’re like most
people, you know that catching a cold is practically inevitable, so it’s not a
shock when you do. Here at Schwartz
Financial, we’ve been expecting a correction for quite some time, so we weren’t
taken by surprise. With that said, it’s
still good to know exactly what caused this particular correction, just as it’s
good to know how and why we watch colds.
After all, fear is in the unknown.
So the more we know, the less we have to fear!
Three Sources of Contagion
Scientists think
there are three different ways we contract the common cold. The first is through airborne droplets called
aerosols. (Unpleasant as it may sound,
imagine someone sneezing in your face to get an idea of how aerosols
work.) The second and third ways are
hand-to-hand and hand-to-surface contact.
(In other words, by touching someone or something that has the virus on
it.)
As it turns out,
there are three main sources behind the correction we’re experiencing:
w China’s stock market crash and
economic slowdown
w Falling oil prices
w Uncertainty over whether the Federal
Reserve will raise interest rates or not
Let’s take a brief
look under the microscope at all three.
China
For a long time,
China’s stock market was on an incredible hot streak. With the state-owned media urging them on,
many people started pouring their money into stocks. The resulting growth was explosive but
unsustainable. As the demand for stocks
increased, so too did stock prices. That
didn’t deter investors, who kept buying as long as stocks looked like they
would keep going up.
Meanwhile, the
overall Chinese economy had actually been slowing down, and, despite its size,
was in fact relatively weak in terms of growth.
Many sectors of the Chinese economy, like construction and
manufacturing, had been financed by cheap credit through the nation’s central
bank rather than by demand. Debt
skyrocketed, and when those sectors (especially manufacturing) inevitably
slowed down, investors awoke to the fact that their nation’s economy wasn’t an
effective prop for their nation’s markets.
This sudden loss in confidence led to a sharp drop in their stock
market. This happened in June, and since
then, both the Chinese market and the Chinese economy have been on shaky
ground.
Why does this affect
us? Well, just as the common cold is
contagious, so too is economic sickness.
In finance, contagion is “the likelihood that significant economic
changes in one country will spread to other countries.” This happens because the global economy is so
interconnected. If China suffers,
businesses and countries that depend on China for their own livelihood will
suffer as well.
For that reason, a
large part of the recent market volatility stems from the fear that China’s
woes will eventually spread to our own shores.
Oil
You’ve seen it at the
pump: oil is much cheaper than it was a year ago. That’s a good thing for consumers! But it’s a bad thing for the energy industry,
which in turn impacts the markets.
The reason oil prices
have fallen goes back to your Economics 101 class: supply and demand. To put it simply, there’s just too much
supply and not enough demand. The United
States, Canada, West Africa, Russia, and the Middle East all produce a tremendous amount of oil. At the same time, many of the countries that
would normally buy oil are experiencing their own hardships, meaning they have
less money to buy it. And as we learned
in Economics 101, when the supply of something is greater than the demand,
prices fall.
Geopolitics might
also play a role. For example, take
Saudi Arabia, the most influential member of OPEC, the Organization of Petroleum Exporting Countries. Saudi Arabia has refused to cut oil
production despite the fact that the world’s supply far outpaces the demand for
it. Why?
Some analysts think it’s because if oil prices were to rise, it would
only benefit Saudi Arabia’s main competitors, especially Russia and Iran, who
all need higher prices to turn a profit.
Saudi Arabia, on the other hand, can survive on lower oil prices because
of their massive cash reserves, and because extracting oil is far less costly
for them. This means that lower oil
prices harm their competitors while leaving them unscathed, allowing them to
dominate more of the market.
Why are oil prices
behind the current volatility? Because
falling oil prices makes life harder for energy companies and companies closely
aligned with the energy industry. The
result is falling stock prices for those companies and the markets as a whole.
The Federal Reserve
For over six years,
the Federal Reserve has played a game of limbo with interest rates. How low can they go? As it turns out, pretty low … almost to
zero. The Fed’s reason for doing this is
that lower interest rates make borrowing less costly. This means businesses and individuals can
borrow and spend more, thereby pumping more money into the economy. The result?
Economic growth.
Keeping interest
rates low, however, can be like using a crutch long after a broken leg has
healed. It might keep you from
re-injuring your leg, but it can also slow you down. Some experts feel the Fed should raise
interest rates in order to prevent possible inflation and to encourage banks to
do more with the money they are currently holding in reserve. Others feel that raising rates, especially if
done too quickly, could derail our nation’s economic recovery, which is still
seen as fragile.
The Fed has made
noises about raising rates for a long time, and whenever they do, the markets
tend to panic. Such is the case
here. It’s the fear and uncertainty over
what the Fed will do—and what the consequences will be—that contributes to our
current market volatility.
Prognosis
So there you have it:
three reasons for the market’s malaise.
But what will happen next? When
will the markets get better?
It’s impossible to
know, of course, just like it’s impossible to know exactly when you’ll get over
a cold. That said, there are a few
historical indications that point to better times just around the corner.
w September is
historically the month when the markets perform the worst, so there was nothing
surprising about this correction happening when it did. Since 1950, the Dow has declined an average
of 1.1% during September.
w October through
December, on the other hand, is traditionally strong for the markets. That’s because the holiday season brings
holiday cheer for retailers. Last year,
the S&P 500 rose more than 4% during that time. A year before, 10%.1
Does that mean things
will magically get better just because it’s October? Of course not. The markets don’t work like that. So instead of trying to predict the course of
the common correction, let’s focus on what we
can do to combat it.
1.
Remember that investing isn’t a race, it’s not a game, and it’s not a
sport, even if the media often covers it that way. Investing is a discipline. Proper
investing, in fact, is a lot like taking care of your own health. It’s about making long-term decisions. It’s about not taking foolish risks.
2.
Remember that just as you won’t assume your next cold will turn into
pneumonia, we won’t assume this correction will turn into a full-blown bear
market. Could it? Sure.
But with a cold, you focus on getting rest and drinking fluids, not on
worst-case scenarios. We’ll focus on
staying committed to our investment strategy, being patient, and keeping an eye
on your portfolio’s health.
3.
When it comes to our physical health, it’s always a good idea to routinely examine our habits. Are we eating nutritiously? Are we getting enough exercise? Are we going in for regular check-ups? As long as the answer is “Yes,” you can feel
pretty confident about your health. With
your portfolio, we’ll do the same. Are
we invested in good companies? Are we
diversified? Are we protecting ourselves
from unnecessary risk? As long as the
answer is “Yes” (and I believe it is), you can feel confident about your
financial health.
The third quarter is
over. The fourth is just beginning. There are a lot of reasons to believe the
year will end on a high note. But even
if it doesn’t, we’ll keep fighting the common correction the way we fight the
common cold: by sticking to the basics, paying attention, and not
overreacting.
By doing that, we can
make the symptoms a lot more bearable.
Of course, if you
have any questions about the current volatility, how your portfolio is doing,
or what the future may hold, please feel free to contact me. In the meantime, my team and I will keep a
close eye on the markets. I may not be a
doctor, but that doesn’t mean I can’t give your portfolio a physical!
