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News, research and market insights from our team of experts.
"El Nino," the warm phase of surface temperature oscillation in the equatorial Pacific Ocean, can wreak havoc on weather patterns thousands of miles away. In their mid-July update, the Climate Prediction Center issued an advisory detailing a 90% chance that the current El Nino would continue through the winter of 2015-16, and an 80% chance of it lasting into the spring of next year. That could mean fewer and weaker hurricanes in the Atlantic this season; more and stronger storms in the Pacific; and more rain in the months ahead for the drought-stricken, fire-prone, western United States. Perhaps a lot more rain. On balance, that all sounds like good news; unless it triggers mudslides and flooding, as strong El Nino patterns have in the past. The state-of-the-art in weather forecasting has advanced considerably in recent years but we still won't know what the final outcome is until it actually happens. We'll have to wait and see.
Similarly, geographically distant events can affect financial markets thousands of miles away, often with unanticipated consequences even when they are accurately forecasted or telegraphed to the markets. We also like to attach clever names to such events as a sort of heuristic or short-cut way of explaining what’s going on – terms like Taper Tantrum, Grexit, the Fed’s Lift Off, Flash Crash, etc. Unlike in meteorology, however, the state-of-the-art in economic and capital market forecasting has not advanced much in recent years despite more and better information and the commitment of considerable effort and resources. Well understood events often have surprising impacts. Some believe this is a sign of market efficiency and the random-walk nature of asset prices – that there simply is no information advantage to be gained through fundamental analysis or the so-called “semi-strong form” of the Efficient Market Hypothesis. Others believe it is simply due to the unpredictable nature of human behavior, even in the aggregate, and that markets have personalities of their own. I firmly believe it is a combination of the two – that there is a bit of Mr. Spock as well as Homer Simpson in all of us, though in varying combinations. Moreover, "markets are people too" and they often behave that way.
We got a taste of such foreign-induced volatility in June and July, as world markets reacted to the drama surrounding the debt crisis in Greece and the stock market collapse in China. Both situations were well understood, though the "final" (for now?) outcomes couldn't be known until the very end. The situation in Greece has been a slow-motion train wreck for years. The process of reaching a "deal" was strung out as far as absolutely possible, well beyond any sense of reason. It reached a final tipping point with the EU basically telling Greece: stay or go, but we're out of patience and our terms only get worse from here. Despite a clear referendum by the people to the contrary, the Greek government acceded to the EU's demands. The Greek Parliament fell into line, their banks finally reopened and everybody breathed a sigh of relief. Disaster was averted. For now.
The Chinese stock market was a classic asset price bubble which unfolded quickly before our very eyes. Pumped-up by government policy encouraging equity ownership, massive leverage and the impulse of speculation, their stock markets doubled over the span of just a year before suddenly turning down. After watching the market drop 30% in less than a month, the Chinese government announced a series of dramatic policy actions in what amounted to a decree that the market slide must stop. They suspended trading, halted new IPOs, limited short-selling, even committed pension assets to support the equity market! It's okay for stock prices to go up, just not down any further. The initial response was a 10% rally on the Shanghai Stock Exchange A Share Index, and another big sigh of relief. For now.
Are these outcomes final? Hardly. These issues will likely be in the news and impacting markets again, possibly soon. We'll have to wait and see. Are these the only well-understood-but-unpredictable situations currently facing investors? Definitely not. To highlight just a couple:
Overconfident investors often think they will have time to react when market conditions begin to change – that they'll have time to get off the island before the hurricane actually hits – and therefore keep risky trades going long after the risk-return trade-off begins to deteriorate. All manner of behavioral factors can cloud judgment at different points in the market cycle. Given the potential for market disruption going forward, staying focused on portfolio risk is as important as ever. Diversification is the key to risk management in a portfolio context – diversification across asset classes, management styles and investment strategies. The future, by its nature, is unpredictable with any precision and nobody knows what's going to happen. But it is always smart to have an emergency kit handy in case the weather gets stormy. We'll have to wait and see.
For more insight into our current advice, please read the accompanying article by Bob Schaefer. In it, Bob details performance of various capital markets through the second quarter and outlines our tactical recommendations going forward.
For more detail on what's happening in China, please read the accompanying article by Brendan O'Sullivan-Hale. Brendan has spent considerable time in China and has some unique insight into what's been driving the economy and markets – both up and down.
The above articles represent the opinions of the authors as of 7.30.15 and are subject to change at any time due to market or economic conditions or other factors.Print