Embrace Market Weakness
Key Takeaways
Recent market weakness has thrown out a host of concerns including talk of the inverted yield curve. This has led to many investors worrying about what it could mean for their returns.
Interestingly, research shows a weak relationship between economic growth and global stock market returns.
Aug and Sep represents the two worst months in a calendar year for market returns. This typically represents a good opportunity for allocation for long term investors.
When looked at in the long run, sell-offs and the volatility that globally diversified investors face are just small speed bumps in your goal.
If you spend 13 minutes a year trying to predict the economy, you have wasted 10 minutes.
The minor market weakness that we have just experienced in August has sparked new fears and has led to a rise in negative news again. One of the issues thrown out yet again was something that had kept investors on edge for over the past year and a half; which was the news of an inverted yield curve.
(CNBC) This classic recession indicator just hit its lowest level since 1981—here's what it means for you
(Bloomberg) What an Inverted Yield Curve Means for Recession Forecasts
A common aphorism is that whatever happens in the economy, is directly related to how the market performs — especially for stocks. So in the case of the inverted yield curve, it generally means that the yields that longer maturity bonds pay is less than the very short-term ones (or T-bills). The inference is that lower long-term yields means the likelihood of slow economic growth as central banks would likely cut interest rates when that happens.
Data from hedge fund AQR shows that the US yield curve had “predicted” all of the US recessions since 1970 (it was less reliable prior to that). However for other markets around the world, its track record was less clear-cut. So as global investors, using one data point as a key determinant in your investment plan is not wise. Lets look at others.
If recessions are to be feared, then weak economic performance should correspondingly lead to weak market returns. So, a common relationship that investors also look at is economic growth and stock market returns. You may be surprised to know that there is very little relationship between the stock market and changes in GDP, according to the Bank of New York Mellon study shown below. An R² of 1 denotes a very strong relationship (in this case between GDP and stock market returns). However, the data below shows an R² of nearly 0 — meaning that there was nearly no relationship between how the stock market and economy performed.
It is interesting because it is very logical to correlate the economy having an effect on corporate profits. However, apart from the economy, there are hundreds of other factors which also affect companies and their profits. For instance, it can be as simple as bad weather to something more serious like fraud.
This lack of correlation between economic growth and stock market returns also carry forward to emerging markets as the chart below shows. Not every recession creates negative stock returns for both developed and emerging countries. As such, trying to use the economic data as a tool to predict future investment results is not going to be a good strategy.
A high growth economy does not necessarily lead to high stock market returns as well. The Economist discussed a study done at the London Business School that looked into this further. The researchers took the records of 83 countries from 1972 to 2009 and ranked them by GDP growth over the previous five years.
Investing each year in the countries with the highest economic growth over the previous five years earned an annual return of 18.4%, but investing in the lowest-growth countries returned 25.1%.
As for the current market weakness, it is nothing to fear as we are in the traditionally weakest months of the calendar year. The chart below shows that August and September are usually negative return months for global stocks from data stretching back till 1987. As to the reasons why this happens? There is no clear cut explanation — from historical agricultural seasonal patterns, traders returning from their summer break, to investment fund flows due to calendar patterns — it could be any one, all, or none of these reasons, your guess is as good as mine.
So will this weakness continue for longer? It is possible. However, momentum of global stocks has not been affected by the recent sell off with both short and long term uptrends still intact (chart below). Furthermore, risk and financial stress indicators have also not risen, which points to the current market weakness as part of a normal healthy correction and not something more ominous.
It is likely that the current market weakness will be temporary. Momentum for global stocks is still strong, financial stress and risk is still benign, and investor optimism has been tempered by the current correction. As such, this temporary market weakness represents good opportunities for investors to allocate more capital from their cash holdings to take advantage of the discounts available in asset prices. After all, when zoomed out and taken into perspective, the volatility that we encounter during our investing journey are mere blips (see chart below).
If you have a well constructed investment plan which catered to the various market outcomes and scenarios that you could encounter along the way — then there is no need to fear. Every weakness should be embraced as an opportunity.
Worried about another market sell-off or want a second opinion on your current investments? Come and have a chat with us.
