The S&P 500 has had the worst start to a year in its history. Investors are worried about China, and the strength of the dollar. The first day of trading, in China, showed the first use of their circuit breaker system. This led to a global sell off of risky assets. Two days later, there circuit breaker system was used again! The market was only open about a half hour, before shutting down for the day again. On Friday the US had a exceptionally strong jobs report, but the trading day still ended up down around 1%. So, what is going on? Why are US investors selling their stock?
To understand why the market is selling, we need to look at the market behavior. We need to take a look at the market participants, and evaluate their reasons for selling.
The first thing you learn in your fundamental economics class is that in order for any theory to work, market participants are assumed to be rational. However, when you look at the stock market, you quickly realize that this assumption is about 50% false. Let us take a look at the rational side of things first.
The market has been on a tear since the Great Recession. It has been uncharacteristically good. If you bought in 2009, 2010, 2011, 2012, 2012, or even at the beginning of 2014, you likely saw some nice gains. So, you have some strong gains, in an uncharacteristically risk-less market. Now comes along 2015. The market does not move. There is the first correction in 3 years. First there was the Grexit, where everybody was uncertain about what would happen in Greece. Then there was the Chinese slowdown, where everybody was scared that a slowdown in China meant a slowdown in the global economy. On top of that, the bond market went into its first bear market in over 25 years. Commodities have plummeted, and oil just kept on falling. Earnings have been weaker and weaker. To top it all off, we had the first rise in interest rates in eight years. Even though all of this was thrown at investors the S&P held its ground. That is pretty remarkable. Now let's look at December 2015. Everybody is expecting this "Santa Clause Rally." Analysts everywhere, on every channel are predicting this rally to come, late into the year, but it never comes. Where does this leave investors?
With the memories of the Great Recession in the backs of their minds, they decide to take what they have gained. They are scattered, and jittery. They want to protect their gains, and make sure that they do not lose everything in a recession, or a big sell-off. With the recession in everybody's minds, they realize the risks of losses, and they remember that the stock market has its risks. The market will always go back down, so protect your gains and sell.
On the irrational side of things, people are actually wanting to buy stocks. They ignore evaluations, and believe the market is going to keep going up. This is entirely possible, but why would you want to risk it? The risk reward ratio has gone up significantly since 2015. You do not take the same risks for 3% growth, that you would with 14% growth. The stock market was not as risky in the previous years, not because the risk was not there. It was just less likely to occur. The Fed basically wanted to improve the economy by pushing up stock prices. With all the economic fundamentals going against the market, coupled with a negative year, it makes the likelihood of a downturn much more reasonable. At the very lease, investors should be rebalancing their portfolios to at least lower some risk.
That is right, it is irrational to believe the market will continue with its previous years strength. In prior years, the confidence of the stock market was strong. Interest rates were as close to zero as possible. The Fed was doing its best to propel the market up. All this has changed though. Interest rates have been raised, and the market is concerned that earnings are starting to slow. Sure you can miss a few percentage points of growth in your portfolio, but at what risk? Especially when you look at a typical portfolio. Even an average 60/40 portfolio, a 3 percent gain in the stock market only translates to a less than 1.5% increase in the portfolio. So instead of 60/40 portfolio, you would expect rational investors to lower stock exposure, and move to less risky assets.
With all of this, you would want to see a gradual step lower in the overall stock market. You should not see a huge drop, or panic selling (until maybe the end). There will be a gradual decrease in stock prices, and we have a well mannered bear market for a little while. At least until valuations decrease, and stocks become cheap again. When earnings show strength again, and global uncertainties start to go away again, people will gain their lost confidence back in the market, and move back into the more risky assets.
Disclaimer: At the time of publication the author is long RWM, DOG, SPH, PSQ. Inverse ETFs of the major US indexes.
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