Markets Can Go Down? Who Knew?

If a family starting investing in stocks on January 1, 2013 and knew nothing about the history of markets, they might be shocked to see their value of these investments actually going down the last week or so.  They might flip on CNBC to find out what’s happening and judging from the hysterics around many commentators, may become more concerned.  Then they might go online or grab their local newspaper and see a picture of these guys (likely floor traders) and might really start freaking out.

The obligatory "Traders Freaking Out" picture Source: Scott Olson / Getty Images

The obligatory “Traders Freaking Out” picture
Source: Scott Olson / Getty Images

So should they be looking to sell out of all their stock and stock funds?  The answer of course is:  It depends.  It depends on their long term goals, their asset allocation strategy and their risk tolerance all wrapped around the considerations of their career situation and family commitments.  Without having those clearly defined in advance of these news-driven turbulence, they are a rudderless ship prone to knee-jerk reactions prompted by inevitable market gyrations.

But before we delve into that broader discussion- let’s take a minute to diagnose what’s actually been happening over the last week that’s causing what I would characterize as a modest sell-off.

From my analysis, it appears global stock market investors have become more risk averse due to a series of global news items.  Currencies in emerging markets such as Turkey, Argentina, South Africa and India losing their value relative to the U.S. Dollar. Governments are trying to stop this from happening as this will mean less purchasing power for their citizens (for imported goods) and likely portends investment capital fleeing those countries.  They do this by raising interest rates. This action theoretically attracts investors (seeking higher interest rates) increases the demand for their currency and keeps investment capital leaving. The flip side to this action, is the higher interest rates, which increase the cost of doing business in those countries and could slow growth.  So it’s a matter of pick your poison for these governments.

Let’s walk through the issues using a series of questions and answers:

What’s causing this recent move?  It could be the realization that the U.S. Federal Reserve will continue to “taper” their bond purchases, as they confirmed again yesterday afternoon. This decision (and forward guidance) had already started to bump ultra-low interest rates here in the U.S.  For global investors, this means there is less of “spread” between the interest paid on U.S. debt (theoretically, the lowest risk asset class) and emerging market debt, which is higher risk.  It’s hard to think this is the only factor, however as it’s been several months since the initial announcement.  It could be just the psychological impact starting to take hold.

So why is the U.S. stock market down?  My first inclination is that institutional investors are probably taking a step back on their equity weightings as valuations are stretched (across many metrics). Realizing this, any sense of uncertainty in global growth, and the potential impact on U.S.-based multi-nationals, gives traders an excuse to take profits.  I could make the argument that this pull-back (to this point) is probably healthy as we’ve seen a very long stretch of stock market growth in the U.S.

What does it mean for the future?  To my earlier point, it depends on your definition of “future”.  If by “future” you mean tomorrow, next week, next month or even a year from now- I don’t know.  The reason I don’t know is that near term trading is very much sentiment driven which is impossible to predict- at least consistently.  If by future you mean 10 or 20 years from now, I’m more confident that emerging markets will be a good place to place at least some portion of a family’s portfolio.

Why do I believe this?  I because investors should have at least some exposure to emerging markets because they are still a small portion of global equity markets. This is despite the fact their purchasing power and growth prospects are much higher than “established” markets like the U.S., Great Britain and Japan.  To put some numbers around that, a recent study by EPFR Global, emerging market stocks constitute about 2% of the assets of global funds.  But purchasing power of those countries has actually just recently overtaken the “advanced economy” according to the IMF.  Another way to look at it is that the value of all the emerging market stocks is only 17% of the world’s total stock market but in terms of GDP (gross domestic product), emerging markets make up just over 50% of the world’s GDP!  Add in the fact that the last 3 years, these markets have underperformed (relative to the U.S.) and have a faster growth rate and it appears to me that the long term prospects for these assets is actually pretty good. Some may argue this growth has been “juiced” by low rates recently, which is fair.  But just looking at demographics alone points to a secular growth rate higher than the aging populations of Japan, Europe and to a lesser extent, the U.S.   Does this means I am recommending clients go “all in” or “overweight” or “time” their allocations here?  No.  Does this also mean emerging markets won’t continue to go down in future?  Again- No. Which leads me to my next point.

Real World Implications for Families Investing Real World Dollars:  Investment allocation in any market should be well-thought out and most importantly, be integrated with a definitive asset allocation strategy that is in line with your goals, risk tolerance and most importantly- time frame.  To my point about diversification: while emerging markets are down one thing that has been less talked about is what’s happened to the yield on the 10-year U.S. Treasury since last week.  The yield on this bond has actually dropped to 2.68% (as of Wednesday evening – 1/29/14) from 2.89% on January 15th. Reminder: this means the price of the bond has gone UP.  This speaks to the value of diversification across asset classes.  Yes the value of your stocks may have declined over the past several weeks. But if you owned some bonds, you’ve seen that stock decline partially offset by what was likely an increase in the value of your bond portfolio.  With a long-term diversification strategy, these asset classes work together to soften the blow of market volatility.

To wrap up:  Nothing has changed in our world of “real world” investing where we have to deal with 401(k)’s, IRA’s 529s and other investment accounts.  My principles remain firmly intact: Diversify your investments, take a long term approach and keep investment costs low through passive investments like index funds.  Most importantly, control what you can control.

It really comes down to a simple choice.  You can worry about those aspects that directly impact your financial lives (like the amount you save, the amount you earn, taxes, proper insurance and estate planning). Or you can flip on CNBC and worry about the current account deficit in Turkey and the inflation rate in Argentina.  Of those sets of “worries” which do you think merits more of your attention today?

2 Comments

  1. I read every article and for the most part, understand what you are saying. Kudos to you…difficult subjects can be hard to explain to neophytes. Thanks

    Reply

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