Market Turmoil - Made In China

Posted on August 25th, 2015 by David Laidlaw

What Happened: Over the last few trading days, the stock market has experienced extreme volatility reminiscent of the movements seen during the financial crisis of 2008/2009.  The S&P 500 has lost roughly 10% in value since Wednesday, August 17.  Yesterday’s market action also suggested that prices were distorted by erratic trading as occurred during the “Flash Crash” of 2010.

Why: We believe the root cause of this volatility is systemic economic weakness in China.  China has invested tremendously in building a manufacturing/export-based economy.  Excess capital has also flowed to construction and real estate prices appreciated rapidly until last year.  In 2014, investment then poured into stocks and that bubble popped in June of this year.  China unexpectedly devalued its currency on August 11 to help its export-based economy. 

Since 1980, China’s GDP has grown from roughly $300 billion to over $10 Trillion increasing its economy 30 fold.  While the US’s economy is still larger than China’s, our output only grew by a factor of 3 over the same time period.  Given China’s extraordinary growth, the world has been relying on the hypothesis that the Chinese consumer would drive global demand for the next couple of decades.  All of the recent statistics and actions suggest that China’s period of accelerated growth is coming to a grinding halt.  The Chinese consumer will continue to buy iPhones and Nikes in future years, but at a much slower rate than anticipated. 

Stocks have been trading at elevated levels compared to earnings and anticipated growth rates for the last couple years.  The market has also not corrected by 10% for four years and has been over-due for a correction and the recent events created a perfect storm of uncertainty. 

Strategy: In the face of this volatility, our strategy will consist of the following:
Fixed-Income: Investment grade bonds have increased in price over the past few days performing their role as a hedge against losses in the stocks.  We will continue to hold bonds in balanced accounts to preserve capital and meet any short-term funding needs.

Stocks: The portfolios that we manage consist of companies with strong business franchises and lower levels of debt compared to the market averages.  Therefore, these stocks are already stress resistant.  We plan on holding the vast majority of stocks in the portfolio until the volatility subsides.  Stock prices may continue to fall, but trying to time bottoms is rarely a winning strategy.

We may sell certain positions for fundamental or tax reasons.  Harvesting tax losses makes sense to reduce capital gains liabilities in taxable portfolios.

We also plan to buy securities opportunistically if prices continue to fall for quality companies.  In 2008, we were able to buy positions such as Google in our Large Cap Core Growth portfolios that depreciated to price levels that we determined were too attractive to ignore.