Global stock markets have had a difficult start this year. The slowdown in China, conflict in the Middle East and falling oil prices are only a few of the contributing factors. As advisors entrusted with managing client assets, we must be prepared to articulate our understanding of the current situation and discuss any strategies we might employ to help minimize their losses. It’s quite possible that some clients will need your help to calm their fears. In this post, I will share a few thoughts on the global situation. 

Overview

To begin, our job is much more difficult when clients are inundated with media reports that a crisis is at hand. Let’s face it, fear sells (and increases ratings). In addition, during bull markets, stock prices tend to rise beyond a reasonable valuation and when a bear market manifests, stocks often overcorrect.

When stocks decline, why is the downside often so extreme? In the current situation, I believe there are two primary reasons. First, there is a legitimate interrelationship between the United States and foreign markets. Even though the U.S. economy is stronger than many other countries, several U.S. based multi-national companies derive a significant portion of their revenue outside the U.S. Thus, there is a contagion effect. This alone would argue for a correction that is in line with the relevant data. What would push stock prices to extreme lows? I believe it is fear; which is the second reason.  Fearoften prompts an irrational over-reaction.

Let’s look at a few of the circumstances that are pushing ‘risk assets’ lower. 

Global Risks

  • China As the world’s second largest economy, the Chinese government spent years building infrastructure. Much of it lies vacant to this day (i.e., ghost cities). In addition, from January 1, 2014, until June 12, 2015, the Shanghai Index rose 144.2%. This was a fast-forming bubble despite China’s weakening GDP.
  • Middle East The Middle East has been the seat of turmoil for thousands of years. When Saudi Arabia recently executed a prominent Shiite cleric (one of 47 executions that same day), the region erupted in protest. Despite this, oil prices have actually moved lower.
  • Oil Price Collapse When crude oil prices collapsed, the U.S. energy sector (and related industries) began to spiral downward. This is leading to numerous bankruptcies, an increase in loan defaults and more unemployed energy sector workers. 
  • Labor Market Although last week’s U.S. jobs report was much better than expected, the labor force participation rate continues to fall. In fact, you have to go back 39 years (October 1977) to find a lower number. This casts a shadow on the low unemployment rate in the U.S. 
  • Strong Dollar The U.S. dollar has been strengthening for a while. A strong dollar is a headwind to the profits of many large U.S.-based corporations. If the Fed continues to raise rates, the dollar may strengthen further, eroding the profits of these companies. 
  • North Korea The country has claimed a recent and successful hydrogen bomb test. Any proliferation of North Korean aggression could destabilize the region and upset financial markets.  

Some of the events today are reminiscent of the late 1970s, making the U.S. election in November 2016 even more significant. Regardless, I recently reduced our stock exposure and am considering the addition of a bear-market ETF if conditions worsen. At some point, oil prices will stabilize or rise, energy stocks will rebound and the broader stock market should participate in the rally.

Here’s the million-dollar question: Is this a temporary correction (i.e. a buying opportunity) or a protracted downturn? Although no one knows for sure, it feels like there is more pain to come.

Until next time, thanks for reading and have a great week!