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Many investors hoped that the turn of the year would bring answers to some of the questions that plagued markets in 2015. What is going on in China? When will oil prices stabilize? Is the stock market trying to tell us something? However, much to their dismay, 2016 seems to have brought with it a new set of questions, as China remains in the headlines, oil prices have declined further, and equity markets have been volatile. So what is an investor to do? Determine whether the facts have changed, and if that warrants an adjustment to one’s investment thesis.
We know the Chinese economy has been in transition; that is what led to a sharp decline in equity markets during August and September of last year. But what has changed since then? The Chinese economy has continued to expand at a modest pace (around 6.5% according to the government), and the transition from an investment-driven economy to a consumption-driven economy has continued to play out. At the current juncture, China is a two-speed economy; manufacturing is struggling due to overcapacity and weaker external demand, but the services sector is gradually expanding. In other words, the facts have not changed, and the recent sell-off in Chinese equity markets seems to have little if anything to do with underlying growth. Rather, it appears to be the result of a retail-heavy investor base that trades according to sentiment rather than fundamentals.
The end of 2015 brought with it a decision by OPEC to keep pumping oil in order to maintain their market share, signaling that oil prices would likely stay lower for longer. The beginning of this year saw another downdraft in oil. But it is generally understood that lower oil prices are a function of excess supply, and since production had not begun to decline, should lower prices really have come as such a surprise?
Finally, how should we interpret recent equity market volatility? One of the most basic principles of finance is that when you buy a share of stock, you are paying for a share of expected future profits. However, S&P 500 earnings growth has been negative since the fourth quarter of 2014, meaning that those profits have not materialized. While earnings growth was extremely robust in the early stages of the recovery, it has cooled off because of a stronger U.S. dollar and lower energy prices. Until these headwinds subside, it seems unlikely that the stock market will trade near its all-time highs. To us, this recent sell-off looks more like a repricing, rather than the beginning of something more serious, and long-term investors should stay the course.
Have the facts changed materially since the end of last year? Well no, not really. As a result, we believe that the most prudent investors will look through these recent market gyrations, remembering that the best approach in the long run is to ignore the noise, and instead, remain balanced and diversified.
Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility.