To borrow from the recent Star Wars sequel, financial market forces have reawakened in a major way. The market’s latest worries – China hard landing, oil price collapse, softening U.S. economic data, and weak corporate earnings – are combining to create a potent brew of negativity. Indeed, current polls of investor sentiment show pessimism at levels last seen at the bottom of the U.S. stock market’s near-50% fall in March 2009. 

During periods of extreme weakness, like the one we are currently experiencing, the natural human tendency is to stop the bleeding by bailing out. Among the worst feelings in the world is to watch one’s life savings erode by events that are entirely out of one’s control.  Yet history has shown that this is the exact opposite of what investors should do who are intent on maximizing the long-term value of their portfolio. An investor who bought the S&P 500 at the absolute worst time in the last decade (October 9, 2007) – at the peak before the worst bear market since 1929 – was back to breakeven in less than five years and is now up about 47% including dividends. From a purely mathematical standpoint, it is always better to buy when markets are down than when markets are making new highs. Emotionally, it is extremely difficult.

Our positive outlook is based upon a careful examination of past severe market declines and the conditions that preceded them. Although history does not provide crystal clear answers, there are several conditions that provide important clues to an impending market crash (defined as declines of 20% or more). By far the most common one is an economic recession. Judging from the U.S. GDP numbers, the solid growth in jobs, and the state of consumer finances, we do not see the seeds of a recession in this data.  Another important telltale sign is the shape of the yield curve, which tends to invert (short rates higher than long rates) when fixed income investors expect a recession.

An inverted yield curve has preceded every recession in the U.S. since the mid-1960s, except for one. Currently, the yield curve is positively sloped (the spread between 2-year and 10-year Treasury notes is 1.18%) and remains a long way from inversion.

The other factors common to bear market declines include: 1) a sharp spike in commodity prices (currently going the other way), 2) aggressive Fed tightening (the Fed has reiterated its go-slow approach), and 3) extreme valuations (at a price/earnings ratio of about 15, the market is now bordering on cheap). In short, none of these warning signals are flashing red.

Nonetheless, there are events out there that are worrying. While we first applauded the decline in energy prices as a boon to U.S. consumers, the magnitude of the decline has become troubling. We initially attributed the price decline to a supply glut cause by the boom in U.S. exploration and the unwillingness of Saudi Arabia to cut production.

However, it now appears that weakening demand may also be playing a bigger role, driven by China’s shriveling appetite for energy. Stabilization in oil prices would increase investor confidence that supply and demand are once again coming into balance.

While China’s exact economic health is notoriously difficult to ascertain (due to the opacity of their data and its questionable accuracy), we do know that China’s direct impact on U.S. economic growth is quite limited: only about 1% of U.S. GDP is dependent upon exports to China.

When markets decline, the reasons for the fall seem to overwhelm the case for optimism. A thoughtful investor needs to step back from the noise and examine the broader themes. As we evaluate the       situation, the absence of the factors that typically precede a major bear market gives us confidence that this is a disturbance in the force rather than a collapse of the Empire.

We thank Bruce Simon, CFA Chief Investment Officer at City National Rochdale for this Special Bulletin.