Why emerging market turmoil is more noise than signal

By Matthew Pierce

"The wisest rule in investment is: when others are selling, buy. When others are buying, sell. Usually, of course, we do the opposite. When everyone else is buying, we assume they know something we don’t, so we buy. Then people start selling, panic sets in, and we sell too." — Jonathan Sacks

After closing 2013 in a euphoria of equity growth, the market opened 2014 with a thud. This is not entirely surprising, nor is it particularly worrisome. A certain amount of volatility in equity markets is normal, if not particularly reassuring.

But if a dip in equity markets causes you excessive heart palpitations, then the equity market is not for you. The long term investors unafraid of such volatility will take advantage of these market corrections to buy more. We suspect that January was not the beginning of something new, but a market reaction to rapid growth in returns over the previous 12 months.

U.S. equity markets dropped across the board in January after posting strong results in the 4rd quarter of 2013. Performance was modestly skewed towards smaller capitalization stocks as large cap stocks underperformed small cap stocks.

Large growth outperformed value and blend, and small growth outperformed small value and blend. Large Cap dropped 3.2% for the quarter (Russell 1000).

Within the sectors of the S&P 500 Index (SPX), eight of the ten sectors declined as utilities (2.9%) and healthcare (0.9%) posted modest gains. Technology beat the index, declining 2.6%. Energy did the worst, off 6.3% as production was down across the board. Consumer Discretionary (down 5.9%) and Consumer Staples (down 5.3%) also did poorly.

Foreign equities performed in line with their U.S. counterparts in U.S. dollars with European markets off 3.8%, Pacific markets off 4.5% and Emerging Markets off 6.6%.

On the contrary, investors diversified in fixed income instruments saw gains in January as interest rates dropped on fears of weakening global growth. The yield on the 10-year US treasury dropped to 2.67% from 3.04% at year end, helping the Barclays Capital Aggregate Bond Index to increase 1.5%. Longer duration bonds also returned healthy monthly gains.

Macro View

The pullback from exceptional 2013 equity returns is noteworthy only in that it occurred in January, a typically strong month for equities. Since 1926, the S&P has lost more than 3.5% in a month nearly 15% of the time.

In addition, in 65 of the last 89 years, the S&P 500 has lost at least 3.5% in a single month. In other words, the loss that we experienced in January is pretty unexceptional and certainly within the bounds of equity investor tolerance for losses.

The primary reason for the January pullback appears to be related to expectations that emerging markets growth will suffer, and we have seen recent weakness in Chinese manufacturing. Currency losses in Turkey, Russia and South Africa partially as result of increasing interest rates in those countries, frightened many investors from the equity sector. It is not clear how emerging markets equity markets will move going forward, but the trend appears to be downward. The fear for the global investor is that this trend will spread to other markets.

In my opinion, the major drivers of 2014 global equity performance continue to be the global economy, the actions of the central banks, and valuations. The US economy still appears to be fairly healthy and central bank actions remain accommodative (albeit somewhat less accommodative than in 2013), which are positive indicators for stock appreciation.

This leaves us with valuation as the likeliest potential negative indicator for US equity losses. According to S&P, the forward price-earnings ratio is 15.4; the 20 year average is 14.9. This differential is small and not inconsistent with the current stage of a five-year bull market rally.

Past US market rallies have ended with this ratio at much higher levels than the current reading. While US equity valuations are higher than they were at the beginning of 2013, we do not believe that they are at unreasonable levels today.

We recognize that a change in consumer sentiment, a drop in expected earnings, or an unforeseen shock may cause a sudden rush to safety out of US equities.

Assuming earnings are constant, every one point change in the PE ratio changes the S&P by nearly 7%. I have no way of knowing this for sure, but if we experience a change in sentiment, we might see a dramatic shift. At the time of this writing, the drivers of such a change in sentiment aren't clearly visible.

Summary

The wisest investment course may appear to be counter-intuitive. When everybody is buying, consider selling. When everyone is selling, consider buying. One of the reasons we like our measured and disciplined approach to asset allocation and portfolio management is that we don't tend to overreact to short term noise, but remain within self-imposed boundaries that we believe will build wealth over the long term.

It is hard to do, especially when fear and confusion surround us, but our reading of the tea leaves is that the recent dip in developed market equities is more noise than signal. We'll keep on following our rules.

Disclaimer: All investments involve risk and various investment strategies will not always be profitable. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.

Matthew Pierce

Matthew Pierce

Island Light Capital Corporation is an investment advisory and consulting firm that specializes in the development of optimally diversified investment