Climbing the Wall of Worry

“If you want to test your memory, try to recall what you were worrying about one year ago today.”

– E. Joseph Cossma

About this time last year, the S&P 500 plummeted over 10% in only four trading days.  On the worst of those four days, the Dow Jones Industrial Average lost more than 1,000 points in a matter of minutes and the CBOE volatility index (VIX) – AKA the “fear index” – peaked above 53 – a level not seen since the Great Recession six years earlier.  Do you remember what triggered the correction?

Those who answered worries about the Chinese economy and fear that the recent decline in oil prices would worsen, please take a bow.  Last August, investors were just beginning to realize that the rapid growth phase of the world’s 2nd-largest economy was coming to an end and feared the slowdown was worse than Chinese officials publicly stated.  Meanwhile, the shale revolution in the U.S. had boosted global oil output by over 4 million barrels a day.  However, that amount was 2 million barrels a day more than the world needed.  Mushrooming inventories sent oil prices spiraling downward.  When China surprised the World by devaluing its currency for several days in a row last August, investors worldwide hit the panic button.

Did markets react appropriately?  It depends on who you ask.  China is transitioning from an export-driven economy to one primarily focused within.  A slowdown is to be expected.  Over the past year, the Chinese economy has stabilized (albeit with a few more surprises for investors in the interim) and is no longer at the top of most investors’ list of worries.  The world still has too much oil, but there’s been a shakeout in the production industry with the strong surviving and the weak going out of business.

Over the past year, more things to worry about have come up.  There have been several terrorist attacks in the western world, stocks went through another correction in January and British voters shocked the world by voting to “get a divorce” from their longtime partner the European Union.  Interest rates on government bonds have gone negative in much of the developed world, putting an even bigger strain on income investors.  U.S. companies have struggled to grow earnings, suffering through the longest stretch of negative quarterly earnings growth rates – five straight quarters – since the Great Recession.

And how have financial markets responded to all of this doom and gloom?  Just the way you would expect – investments in nearly every category have moved higher over the last 12 months.  The S&P 500 has gained over 19% and has eclipsed the May 2015 all-time high.  The Barclays Aggregate Bond Index is up 5.8% while the Bloomberg Commodities Index is nearly back to where it was a year ago.  Even international stocks are higher than they were a year ago, with developed markets stocks up 3.2% and emerging markets stocks higher by 16.9%.

Why have markets performed so well despite all of the bad news?  One could make a pretty convincing argument the gains are an unintended consequence of actions taken by the world’s central bankers to pick economic growth up off the mat before the referee counts to 10.  Negative interest rate policies were unveiled by bankers in Japan and Europe with the hope that charging interest instead of paying it would encourage spending.  Instead it encouraged investors to hang on to interest-bearing investments, driving prices up and yields down.  As a result, we now live in a world in which over 13% of the world’s bonds have negative yields and the average stock yields more than the average bond.  Despite all of the negative news over the past year, investor demand for income has outflanked the well-intended actions taken by central bankers.

That puts us in a low-yield environment with equity valuations near the high end of their historical range and weak economic growth in most parts of the world.  We are entering what have historically been two of the worst months for stocks, particularly in presidential election years.  But there are reasons for optimism.

For starters, analysts expect corporate earnings to finally begin growing again in the 3rd quarter and accelerate over the next year.  Investor sentiment readings are in neutral territory.  Inflation is quite tame and unemployment remains low.  Though valuations may be elevated, there aren’t any obvious signs of trouble in the near-term.  As we pointed out earlier though, markets don’t always react the way most investors expect.  It’s for this reason that we constantly seek to identify sources of risk and pursue strategies to limit it.

Whether you are bullish or bearish about the markets, it should not change your investment approach.  Carefully consider your objectives and risk tolerance, and remain disciplined with a long-term perspective.