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Expert Perspective

News, research and market insights from our team of experts.

Investment e.Perspective

Current Issue | April 27, 2017

Proceed with Caution

By: Mark Green, CFA, Chief Investment Officer and Oxford Investment Fellow


Editor's Note: The accompanying two articles by Jim Mahoney and Jared Nishida were written in the days prior to the recent market turmoil. In hindsight, we could have titled them differently – maybe "Take Cover Immediately" and "Death of the Bull Market" – but we'll stick with the original titles and reiterate that the underlying message remains the same.

The recent sell-off in global financial markets should come as no surprise. Careful readers of this newsletter will have noticed a cautionary tone in recent months, reflecting our concern over equity market valuation, global economic growth and expectations for monetary policy and interest rates. We have emphasized the importance of behavioral factors in investment decision making, individually and collectively, which can allow trends in markets to last longer than they otherwise "should" in a truly rational environment.

The timing and speed of market pullbacks is always difficult to predict, as are tornadoes, even when we know the necessary conditions for such events are firmly in place. The speed and depth of the recent sell-off – first in China, then in other parts of world – are a reminder that markets can and will be volatile. The shock that some may feel when downside volatility hits is the flip-side of the complacency they feel in low volatility periods when markets grind steadily higher – much as we have experienced over the past four years. We're simply not used to this type of market action. Moreover, human nature leads us to look for causal events, a catalyst or trigger, something we can point to as a "reason" for things to suddenly be different.

The media is happy to provide excuses: "Fears of global economic slowdown," "Worry about higher interest rates," "Concern over valuation," etc. Yes, those are important, but they are not new. In fact, they have been firmly embedded in the Wall of Worry that investors have been climbing for several quarters. Often, the reason markets shift direction is simply that there is no reason for things to continue as they have, especially when market conditions become extreme. Reason prevails, if you will.

  • The Chinese stock market doubles over the past year, while their economy slows and their policy makers send confusing signals – can that continue?
  • Corporate bond spreads over Treasuries collapse to historic lows, driven in part by a late-cycle reach for yield – is that stable?
  • The US equity market moves higher on the basis of only a handful of rising stocks – is that sustainable?

In the push-and-pull of rational vs. behavioral factors that drive investment decisions, there is a standing tension between momentum and reversal that underlies the cyclical nature of markets.

How far will the current sell-off go? Is this a "correction" or a new "bear market"? Should we worry about the stability of the international financial system like in 2008-2009? Clearly the equity market has been due for a pullback. It has been four years since the broad US market experienced a 10% decline – something that normally happens every year or so. That correction zone (down 10% to 20%) is healthy over the long-term, like periodic fires that keep the forest clear of debris. Suppress the fires long enough for debris to build up and a random lightning strike can destroy the whole forest. We've let a lot of tinder build-up in the markets since the end of the financial crisis and the fire currently raging will likely get pretty hot before it burns itself out. We have recommended reducing portfolio risk in recent months for this very reason. While there may be opportunities for rebalancing, we remain cautious overall and do not believe this is the time to become more aggressive in portfolio construction.

The above article represents the opinions of the author as of 8.25.15 and is subject to change at any time due to market or economic conditions or other factors.