"Be fearful when others are greedy and greedy when others are fearful." - Warren Buffet
The mettle of investors has been severely tested over the last few weeks. Since the market's recent June highs, a litany of issues in Greece, Iran, and China have plagued the stock markets (of which I have written about here and here). Emerging markets have reached bear market territory while U.S. large cap indices have broached the "correction" juncture. U.S. small cap is in a bear market as well. Long term U.S. Treasuries have rallied. The dollar has weakened. Commodities, including oil, have tanked. It's enough to make an investor's head spin.
The fallout from the recent market downturn will come to pass. Bear markets come in a variety of flavors, one of which is a valuation-based bear market. As I have written previously (here), the U.S. stock market is not at a valuation level which typically elicits such a downturn. This is not to say that markets will not continue to be volatile and drop further. Unfortunately, another version of the notorious bear is panic-based. These can be driven by anything from liquidity contraction to geopolitical events to temporary systemic collapses. Financial markets are extremely complex and highly interconnected, so movement in one facet tends to have repercussions elsewhere. The problem with panic-based markets is that market action is dependent on human behavior. Human behavior is highly unpredictable so it is almost impossible to determine when a bottom in panic-based markets will occur--except in hindsight. Panic-based bears tend to act as a release valve when market excesses or imbalances have built up.
In his book, "The Wisdom of Crowds," author James Surowiecki notes four preconditions under which crowds (think of the stock market as a giant crowd of investors) make good collective decisions: diversity of opinion, independence, decentralization, and aggregation. One could argue that a side effect of Quantitative Easing (QE) is a violation all of these preconditions. Asset purchases by government entities--the U.S. Federal Reserve, Bank of Japan, European Central Bank, and People's Bank of China--are not based on underlying fundamentals. They are by definition centralized and non-independent actors whose agendas are informed equally by backward looking inflation and employment data and forward looking prognostications. Finally, the shear size of government entity purchases negates the ability of opinions to be properly aggregated through asset prices. The rest of the crowd, you and me, is effectively crowded-out when actors with unlimited checkbooks enter financial markets, hence the adage "don't fight the Fed."
A number of significant trends are underway, which will cause continued volatility, but are signs the market is healthy in the long run. Monetary policy is beginning the slow process of normalization. The U.S. concluded its dance with QE last October. Europe, Japan, and China are in the midst of their own QE, but they too will likely complete their programs within the next two to three years as their economies return to more stable growth. In anticipation of further monetary tightening, the U.S. dollar (USD) appreciated over 20% in a very short amount of time. I say "further" monetary tightening because the end of QE was a de facto tightening of monetary policy. The FOMC would be better advised to simply let a slew of Treasury securities mature in the coming years as another implicit tightening, rather than poke the bear of market sentiment via an explicit discount rate hike.
We are just beginning to understand the true implications of USD strength on earnings as multi-nationals cope with their newfound competitive disadvantage. Foreign revenues accounted for nearly half of S&P 500 revenues last year. Since 2000, the portion of S&P 500 earnings from foreign sources has been growing at twice the rate of domestic earnings. A Fed rate hike at this juncture would provide a significant headwind for U.S. stocks while also withdrawing liquidity from global markets. While USD strength may result in significant headwinds for domestic stocks, certain developed and emerging stock markets look attractive on a relative basis for the same reasons.
I often refer to the foreign markets as purgatory for pessimists. Rarely are waters anything but turbulent in global stock markets. It seems that even when the waters are calm, CNBC and the 24 hour news cycle find a way to portray them as otherwise. Don't hit the panic button. Investors with the fortitude to invest for the long-term will add money incrementally in the coming weeks and months because they understand that markets are cyclical. They will rebalance portfolios to target allocations according to investment policy statements in order to realize gains from the rally in bond assets, while reallocating to stocks. They will not liquidate portfolios. They will add strategically to the most beaten down portions of the market because they know that fear is a fleeting phenomenon.