A few weeks ago I blogged about what was happening in Greece and the impact on the sharemarket, but while Greece was certainly the 'loudest' issue at the time, it wasn't the only issue...

There's been a long standing debate over whether or not markets are rational and efficient. Some experts argue that the sharemarket automatically factors in any news – good or bad – before anyone has a chance to do anything about it.

There are some fairly reasonable arguments, but for me it all falls apart with one significant element – human nature. Wherever there is emotion there is the chance of irrational behaviour and there's a lot of emotion involved in the movement of our sharemarket at the moment.

So let's focus on the facts and try to get some perspective on what's really going on and what it means for us in the scheme of things.

Since April we have seen several major sharemarkets have decent corrections, eg Chinese shares -32%, Asian shares (ex Japan) -17%, emerging market shares -16%, Eurozone shares -13% and Australian shares. Of course the US share market has been relatively stable with at most a 4% pull back, although being virtually flat year to date it might be described as being in a "stealth correction".

So what are the current issues?

  • Uncertainty remains in relation to China following recent softer economic data, continuing volatility in Chinese shares and China's move to devalue the Renminbi by 3% and allow market forces to play a greater role in its determination.

  • The commodity sector is experiencing a bear market due to more supply than demand, slowing growth in China and the rising trend in the value of the $US (most commodities are priced in US dollars). At present it seems the negative impact of falling commodity prices on producers (eg, US energy companies) is dominating the positive effect on commodity users (eg, US consumers). And China's currency devaluation is seen as reducing demand for them particularly to the extent it makes Chinese producers more economic.

  • The end of the commodity boom effectively ended the strength of emerging markets. Slower growth in China is not helping and the devaluation of the Renminbi has helped accelerate the collapse in emerging market currencies (which are down 36% from their 2011 high). The problems in the emerging world are weighing on global growth as they are now more than 50% of world GDP.

  • Greek related Eurozone risks could re-emerge, albeit briefly. While Greece and the Eurozone have agreed on a third bailout program, Greece is heading back to the polls in a month and the IMF is likely to insist that Greece's debt burden is reduced before participating in the bailout with a decision due in October. Neither of these are likely to be major threats though however, uncertainty around either or both of these could cause short term nervousness.

  • The combination of slower growth in China, falling commodity prices, weakness in the emerging world and the fragility of growth in developed countries indicate the risk of deflation globally remains high. Just to explain – where inflation reduces the value of money over time; deflation increases the value of money –- the currency of a national or regional economy. This means you can buy more goods with the same amount of money over time. In some ways this is good as a slower global recovery means less inflation and a longer global recovery. But it also poses risks for profits.

  • The Fed (the central banking system in US) appears to be heading towards a rate hike - and it's worth remembering here that the current rate is 0% so I use the term 'hike' a bit loosely. But the start of a rising cycle in US interest rates is often associated with market volatility because of this uncertainty. How far will it go? Is the Fed going to stifle growth? The start of the last two major interest rate tightening cycles by the Fed in 1994 and 2004 were associated with falls in US shares of 9% and 8% respectively.

    Investors have now grown used to near zero interest rates for more than 6 years in the US and there is naturally fear that raising them will threaten the still fragile US and global economies. And remember that element we can't ignore when it comes sharemarket movement – human nature and emotion...

  • Australian shares are not being helped by a somewhat disappointing start to the local earnings reporting season. So far 46% of companies have beaten expectations and 61% have seen profits rise from a year ago which is okay, but it's down on what was seen in the February reports, and given the tendency for good results to come early there is a risk of slippage as the reporting season continues.

  • Should mention that reduced liquidity across markets has played a critical role in what's been going on, as there's been a selling-off of equities so that people can get access to cash. Reduced liquidity isn't actually unusual at this time of the year when the northern hemisphere is on summer holidays and creates an environment where market developments can generate more sizeable moves.

 

From this perspective the recent correction is reasonable and not out of the ordinary. From a portfolio perspective, our recommended equity funds have been well-positioned to weather the downturn, and most investment managers have allowed for this in their planning. It can also position them well to take advantage of future buying opportunities.

In a liquidity driven market we are looking for events that could trigger an end to the selling. We see the following possibilities:

  1. A Chinese stimulus package would be helpful but it would need to be large enough to restore some confidence to Chinese investors. There is speculation of the liquidity injection this week.
  1. Markets become absolutely cheap enough. We are probably close in this respect although we do not think the US is there yet. However given the speed of the falls it is not that far off causing valuation support to cause a change in asset allocations and money back into equities. 

So it all begs the question, is the current weakness is just a correction or the start of a new bear market? Periodic sharp falls in the range of 5% to even 20% are quite normal and healthy in that they help the market let off steam and the rising trend resume. Of course it becomes more concerning if the rising trend in share prices gives way to a declining trend and a new bear market sets in.

First up, it's important to point out that notwithstanding the issues I've just discussed, it should also be recognised that the seasonal pattern for shares typically sees rougher returns over the period May to November. This is consistent with the old saying "sell in May and go away, buy again on St Leger's Day" (a UK horse race in September).

We really don't feel this is the end of the bull market - shares are not seeing the sort of conditions that normally precede a new cyclical bear market.

  • Share market valuations are mostly okay. Sure, measured in isolation against their own history some share markets are not cheap anymore. However, once the gap between share market earnings yields and bond yields is allowed for, shares still look cheap.

  • While global economic growth is constrained, a slower recovery should mean a longer recovery as it means spare capacity remains significant and we are a long way from the sort of inflation and debt excesses that precede cyclical downturns/recessions. In terms of current specific concerns: China is unlikely to allow growth to slip much lower for the simple reason that it will lead to social unrest, lower commodity prices will ultimately be positive for growth in developed and Asian economies which are mostly commodity users and while parts of the emerging world will remain weak a re-run of the 1997-98 crisis looks unlikely as the conditions today are very different.
  • Global monetary conditions look set to remain easy. Continued spare capacity and the lack of inflationary pressure has seen global monetary conditions ease not tighten this year. And while the Fed may raise interest rates by year end, they will still remain very low (in a range of 0.25% to 0.5%) and the Fed is likely to signal that any further moves are likely to be gradual, unlike in past tightening cycles. So monetary conditions in the US and globally are likely to remain easy for a long while.
  • Finally, shares are a long way from being over loved. There's a famous quote by the late billionaire investor Sir John Templeton, who said "bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria". There still looks to be a lot of scepticism out there and we haven't hit anywhere near euphoria. In fact various measures of investor sentiment are showing high levels of pessimism which is a bullish sign from a contrarian perspective. This is particularly the case in relation to Asian and emerging market shares.

From Australia's perspective there are a range of reasons to be optimistic. 

  • The size of the fall of 15% is quite a substantial correction especially given the economic outlook has not changed substantially. Sentiment indicators have turned sharply negative (which is a bullish indicator) and investors are heavily underweight emerging market positions. 
  • Valuation and yield looks very attractive relative to low interest rates and relative to global comparatives.

  • The risk for markets appears to be in the resource related sectors. However resources represent only 15% of the market (was 30% a few years ago) and the declining A$ will provide a cushion for the non-mining sectors of the economy (and their earnings).

  • Corporate balance sheets remain in good shape. Net debt to equity sits at 40% compared to 55% pre GFC. There are some pockets of stress in resources and mining services but it is not widespread. 

  • Australia has greater ability to stimulate the economy with interest rates at 2% (high compared to other markets) and Government debt at 23% of GDP.

So in summary, you can't ignore that there are some negative forces in the economy and sharemarket at the moment. In particular, the situation in China, the reaction to a US rate 'hike' and reduced liquidity are probably the three main factors to be keeping an eye on.

And if you're an investor, then it's important to separate out the noise of the market during this latest bout of volatility and focus on the fundamentals of the companies and investments within your portfolio. Those companies with good balance sheets and quality businesses can actually emerge stronger from these types of disruptions. 

But of course, uncertainty leads to volatility in the short term and all markets will experience this from risk aversion.

In our view, it will be a bumpy ride and as such, caution and patience are key.

Ultimately, you shouldn't be overly concerned about market fluctuations if you have a long-term financial strategy in place to effectively cope with short-term falls in the sharemarket.

We believe that market volatility will continue for a while and as many of our current financial planning clients already know, we believe times like this usually call for some strategic defensive positioning. In particular, holding enough equity exposure to take advantage of any market rallies over the next 6-12 months, but also putting measures in place to help protect against "downside" risk.

For this reason we prefer strategies that include tactical decisions, rather than "set and forget" which is somewhat redundant in this environment.

Cheers,

Michael