Much ado about everything

Aidan Donnelly reports on the recent movements and warns investors to take a long-term view rather than a quick-fired reaction to a swoon in markets.

So, I hear you say, equity markets have been in a bit of a funk for the last few months. Having reached highs – in the case of the S&P 500, all-time highs – on September 18th, markets have headed lower in choppy daily moves.

Faced with this picture it is only natural that I repeatedly hear the phrase ‘there must be some critical issue to explain such a fall’. You would think that would be the case alright, but its not that simple.

One of the first things to do when writing an article like this is to look back at what the many market gurus – please note I don’t include myself in this hallowed company – who have been opining to explain the swoon in markets.

Naturally, I thought that if there was a definitive reason for the move, it would be discussed by this cohort of people.

Sure enough, the reason or, more correctly, reasons, were there in black and white.

And the reason is …

If you haven’t realised already, this last revelation was somewhat tongue-in-cheek. In reality however, the reasons put forward to explain the markets’ movements over recent weeks have ranged from a bear market in ‘small cap’ stocks; crude oil plummeting; Hong Kong demonstrations; Ebola cases in the US and Europe; European Central Bank (ECB) being behind the curve; seasonal weakness (always a good one when all else fails); high yield debt sell-off; and my personal favourite – iPhones that bend – I kid you not.

This is not to make light of the recent move in equity markets, but it is worth noting that the fall seen over this period is not even the largest peak-to-trough decline this year, never mind longer than that. So a little perspective is no bad thing.

There is no denying that there are genuine issues that investors need to be cognisant of, but getting caught up in the day-to-day noise usually results in two things – the first is heightened levels of confusion and the second is probably doing something stupid in reaction.

Not as simple as it seems

The problem with an exercise like this is that in most cases we are looking for post event rationalisations, and the more obvious the explanation, the better.

Of course no one wants to read stories about demonstrations on the streets or the spread of killer viruses, but the reality is the impact is more likely to be a ‘sentiment’ rather than a fundamental one.

While the headlines of ‘small cap bear markets’ or ‘collapsing oil prices’ are technically correct – albeit hyperbolic – putting them in context reveals something less sinister. The small cap stock markets have risen significantly over the last three years, so to see a pullback of 10% is hardly surprising.

And as for the oil price: well, in this case it is a seasonal effect as we move from the high demand months of summer (for driving season) and winter (for heating) we have what is called the ‘shoulder months’ of lower prices.

The pending impact

I would love to tell you that I have an investment thesis that explains why the bending iPhone has a stock market impact, but I think the less said about that the better.

Instead, it is worth addressing the factors that are likely to impact the future direction of markets. In this regard, at the top of the list are the actions of the central banks on both sides of the Atlantic. Some 35 years ago the US Federal Reserve (Fed), under Paul Volker, made its first foray into ‘unconventional’ monetary policy, as the central bank rapidly raised interest rates to over 20% to crush double-digit inflation.

While successful on the inflation front, it came at the cost of the worst economic downturn since the Great Depression.

Mirror mirror

Fast-forward to now and the mirror image is in place – low inflation, zero interest rates and an economy recovering from the fall-out of the financial crisis.
The similarity comes from the fact that the Fed also reached into its ‘unconventional’ toolbox to aid the recovery as it pumped vast amounts of liquidity into the economy in the form of quantitative easing (QE).

There have been so many policy surprises from the ECB recently that the market was left a bit deflated …”

But the Fed will turn off the QE tap at the end of October and with that comes the risk of increased volatility as the markets adjust.

To QE or not to QE?

There have been so many policy surprises from the ECB recently that the market was left a bit deflated by the lack of another rabbit emerging from Draghi’s hat after their last meeting. There had been much ‘talk’ on the topic of QE coming from Draghi and his cohorts for the last year and while we were beginning to see evidence of the follow-up ‘walk’ over the summer months, the meeting at the beginning of October left markets feeling the walk has slowed to a crawl, when they had been hoping for a jog.

It seems that the ECB has returned to a policy of wanting to see the impact of its prior initiatives before undertaking any fresh intervention. By adapting this policy, the ECB runs the risk of irritating investors, especially if it continues for a protracted period of time.

Earning expectations

The other major factor to impact markets is corporate earnings and we are now making our way through Q3 reporting season.

Over the course of the third quarter, analysts have lowered earnings estimates for companies with issues like weakness in Europe, with currency and commodity price fluctuations being cited.

As we move through the final weeks of the year, the focus of companies and analysts will switch to 2015 and with it the prospects for profit growth next year.

Any deterioration in the outlook will weigh heavy on both fundamentals and investor sentiment.

Given the amount of ‘market noise’ that bombards us on a daily basis, I might leave the last word to Warren Buffet. In a recent interview he was asked his views on some of the upcoming ‘important’ monthly economic stats. After some consideration the ‘Sage of Omaha’ replied that he had bought the See’s Candies company in 1972 and therefore it didn’t matter about monthly unemployment if he is going to own the stock for 50 years – a long-term perspective indeed!