Market Update: Latest Thoughts on Market Volatility

Stick to your plan, despite the natural emotional response to sell. As difficult as it is in periods of heightened volatility, we encourage advisors and clients to stick with their plan. The natural reaction is to sell and go to cash, but that is rarely the right decision. That said, there may be times when it makes sense to lower a portfolioís risk level, which can create flexibility to pursue more attractive opportunities as they arise. We suggest everyone take some level of action to protect, but not panic. And remember that when we create an asset allocation, we not only assume an average return, but also significant volatility around that average.

b99fe63e-58ac-4a4c-802a-6484527357d6Investor sentiment is nearing extreme levels of fear. Investor surveys are showing a dearth of bulls, which could be a positive from a contrarian point of view.†In fact, the American Association of Individual Investors (AAII) this week reported that bulls come in at only 18%, the lowest reading in nearly 11 years. Meanwhile, the percentage of bears spiked up to 45%, the highest level in nearly three years. This level of pessimism and increased level of market volatility suggest to us that most of the potential stock market decline is probably behind us. The S&P 500 is currently trading at near 1875, very close to the lows of 2015, which we believe represents an important level to hold from a technical perspective.

When volatility rises, be more tactical. With markets becoming more volatile later in the cycle, a tactical response of lowering portfolio risk as markets turn fearful becomes more viable, something we have done in some of our portfolios in recent weeks. However, at the same time, we would use the volatility to look for opportunities to add back risk. We expected volatility to rise this year but none of us expected it to happen so fast. Keep in mind this level of volatility, in terms of drawdowns of 10-15%, are normal at this stage of the market cycle (the S&P 500 is down about 10% from the November 3, 2015 highs). In fact, even in positive years for the S&P 500, the average drawdown is 11%.

Oil a key factor in the marketís quest for a bottom. The oil market remains oversupplied and we would not expect a major rally in oil until supply comes off the market. However, we do not think that low oil prices, in and of themselves, can cause a recession in the U.S. or lead to a systemic contagion risk, such as what occurred during the financial crisis.

Chinese economic rebalancing has been difficult. China is rebalancing its economy to be more consumption based and less reliant on construction and infrastructure. This transition has been painful. However, China also has vast resources to ease this transition. Acknowledgement of the problem and concrete steps to fix it should boost, not further hinder, the global economy.

We do not believe that China weakness and low oil prices will pull the U.S into recession. The U.S. non-manufacturing Institute for Supply Management (ISM) data recently released indicated that the service sector is stronger now than it was during oilís peak in 2014. As the service sector accounts for 80-90% of the economy, we do not see major impacts from either China or lower oil on U.S. gross domestic product (GDP). Note that China accounts for only about 7% of U.S. exports.

U.S. economic growth to continue despite oil price collapse. The U.S. economy is continuing to feel both sides of the oil price collapse. Capital spending and manufacturing (about 15% of the economy) will be hurt by the latest leg down on oil, but consumers, which represent about two-thirds of the U.S. economy, will benefit via lower gasoline and heating oil costs. The economy was growing near 2% as 2015 ended and will grow close to 2.5% in 2016, in our view. Given then tightening of financial conditions in recent weeks, the Federal Reserve (Fed) is likely to further soften its already gradual approach to rate hikes this year.

Valuations have become more reasonable. One of the more common worries about the ongoing bull market has been valuations. They have been above long-term averages recently, but the latest stock market correction has brought stocks down to more reasonable price-to-earnings ratios (PE), below 15, down from more than 17 back in March 2015 (based on S&P 500 forward consensus estimates). While valuations alone do not drive our investment decisions, they can help entice buyers when stocks fall, especially when bonds do not provide a very attractive alternative at such low interest rate levels. In fact, the dividend yield for the S&P 500 at 2.3% as of today (January 15) is higher than the yield on 10-year Treasury bonds at 2.02%. Corporate America, outside of the challenged energy sector, remains in very good shape and, we believe, is in good position to grow profits in 2016 despite the drags from the energy sector, a strong U.S. dollar, and slower growth in China.

The PE ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share.