Market Reality Check: What to Make of the Recent Decline

Bryan Pratt By | On August 24, 2015

The past week, August 17th – 21st, was rough for financial markets, especially here in the U.S., and it looks like the damage is continuing as we start the final week of August. As of Monday morning, Asian and European markets are down, with China getting hit particularly hard, and U.S. markets opening with some of the largest point drops ever seen.

Reasons to worry, especially out of China

The pullback brought the S&P 500 Index to its lowest level since January, taking returns for the year so far into negative territory. Even more significant, the decline convincingly cracked the 200-day moving average, often a sign of further weakness. Damage has been done on a technical level, and confidence appears to have dropped.

But there are bigger reasons to worry outside the U.S. China’s economy is showing continued weakness, with a key manufacturing survey coming in at the lowest level in more than six years. Currency strains are showing up in emerging markets as the effects of the Chinese yuan devaluation work through the system.

Indeed, China is at the core of the problem. As the primary contributor to global growth during the latest recovery, when China sneezes, the rest of the world catches cold. Given slowing Chinese growth, a stock market correction, and a shock currency devaluation, it’s no wonder investors are pulling back from risk around the world, and many countries are getting caught in the downdraft.

Still, the U.S. should continue to fare well

Certainly, there are valid reasons to be worried, and many countries ought to be. But there’s also plenty of evidence that U.S. markets should continue to do well. For example:

  • Overall structure of the economy. We have relatively little exposure to foreign trade, and our exports to China are much less than our imports. This has been a drag on growth so far, but it also means we have less exposure to a slowdown there.
  • Strong currency. Although it has hurt U.S. corporate profits this year, the strength of the dollar reflects the relative strength of the economy. In fact, the strong dollar has made imports cheaper, boosting both companies’ and the average consumer’s ability to buy things.
  • Limited financial exposure. Combined with the strong dollar, the reforms to the financial system enacted since the crisis mean that we’re much less exposed to financial contagion than almost any other country in the world.

 

The U.S. does face some risk, of course, but much less than what other countries are looking at. A quick review of recent history bears that out. In the Asian financial crisis, for example, U.S. markets saw a pullback but then rallied and moved on to new highs. As recently as October of last year, U.S. markets recovered from a similar drop. If we look back a full year, the stock market still shows a gain.

This used to be called normal volatility. The decline so far is minor and normal by historical standards.

The appropriate response

We don’t want to minimize the situation, but one bad day doesn’t make a bear market. We may well see further declines, but the fundamentals remain very strong, especially here in the U.S. Employment and income growth are steady, housing has normalized, and Federal Reserve policy remains quite supportive of economic growth. Weakness elsewhere in the world may also act as a support for the U.S. economy.

For investors, a drop like this one underscores the need to plan for a significant and sustained decline in the market. It could be now—more likely it will be later—but it will happen at some point. A market dip should prompt you to review your plans for trouble and ensure that they still meet your needs.

 

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Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is no guarantee of future results. Authored primarily by Brad McMillan, CFA®, CAIA, MAI, chief investment officer at Commonwealth Financial Network with edits by Bryan Pratt, CFP®. © 2015 Commonwealth Financial Network®