If there is increased market concern about global growth in general or specific to emerging markets/China, we would not be surprised to see the recent pattern continue, where emerging-markets equities fall more than developed markets and European stocks fall somewhat more than U.S. stocks. This is because the U.S. economy is still likely to be viewed as the strongest of the weak, and U.S. stocks as the best alternative among global equity markets. The fact that emerging-markets and European stocks may be undervalued in absolute terms as well as relative to the U.S. stock market will likely have little impact on their short-term performance in such a scenario.
Alternatively, if global economic fears subside, for example due to signs of stability or improvement in China’s economy and stock market, we wouldn’t be surprised to see the converse pattern, with the beaten-down, inexpensive, out-of-favor, and more cyclically sensitive emerging-markets stocks staging a stronger rebound than U.S. stocks and European stocks outperforming U.S. stocks for similar if less extreme reasons. Having said all that, these are just a few of the short-term outcomes we are cognizant of and prepared for.
In the opening section of our commentary, we provided a brief overview of the frequency of U.S. stock market corrections and bear markets since World War II, the point being that 10%-plus declines are very common and even 20%-plus drops have occurred every five years, on average. There is another interesting historical fact that we see frequently mentioned by market commentators, which is that stock market corrections typically (though not always) only turn into bear markets when the economy is nearing or in a recession. Recessions are associated with sharp declines in corporate earnings and investor risk aversion, so a linkage between falling stock prices and recessions certainly makes sense (although it’s also the case that not every recession has been associated with a bear market).
After making the historical point about bear markets and recessions, the market commentator will then typically point out that based on various economic indicators, there is little risk of an impending recession in the United States. Therefore, they conclude the risk of the current market correction turning into a bear market decline is low.
There is a comforting logic to such arguments, and indeed there seem to be few signs of recession (at least in the United States; the story is different in the emerging markets, with Russia and Brazil already in recession). However, we need to point out one fly in the ointment: economists and market strategists are notoriously bad at predicting recessions! The chart to the right shows the consensus forecast has never predicted one going back to the 1970s.
So the fact that most economists see very little chance of a recession doesn’t give us much comfort. This doesn’t mean the consensus is definitely wrong and that a recession is brewing. It just means that whenever the next recession does come, they (and most investors) will not have predicted it. (There will be a few people who get the call right each cycle—whether due to luck or foresight—but rarely will it be the same ones from cycle to cycle.) We don’t think we have any skill in forecasting recessions either, which is why we don’t bother trying to do it, nor base our investment decisions on such predictions.
Instead, as part of our scenario analysis we think about the risks of a recession or an economic shock and the implications for asset class returns. We also try to have some sense of where we may be in the economic and financial market cycles. But no two cycles across history are identical, and there are countless, ever-changing micro- and macroeconomic variables that impact the duration and magnitude of these cycles. So, we also think about what may be different this time around compared to the past—for example, the impact of emerging markets, and China in particular given its importance in the global economy and markets.
The reality of owning stocks is that occasionally, inevitably, we will experience bear market losses. This underscores the importance of our risk management, in which we seek to reduce our balanced portfolios’ vulnerability to stock market downturns through strategies that include owning “insurance” assets such as bonds and lower-risk alternatives. Another key ingredient in managing through bear markets is helping our clients accurately assess their risk tolerances and investment objectives. If you are in an appropriately structured portfolio, there is no benefit to selling in a market downturn. In fact, by doing so you risk selling nearer to the bottom and then missing the subsequent recovery. Instead, we are likely to view such downturns as potential buying opportunities—exemplified by our recent increase in emerging-markets stocks. This is based on our tactical asset allocation approach that centers on analyzing long-term fundamentals and valuations, while remaining sensitive to shorter-term portfolio risks.
This information is provided for general information only, and is not intended as personalized investment advice. Reading the above is in no way intended to be a substitute for individualized investment advice, and no conclusions should be drawn from this information regarding any potential investment. Certain material in this work is proprietary to and copyrighted by Litman/Gregory Analytics and is used by Capital Trust & Associates, LLC with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.