１）The U.S. economy is growing.
The consumer is in pretty good shape, still paying down debt from the housing bubble. Household debt to GDP has gone from 98% to 78%, and that’s a good thing. Deleveraging is good, but it also takes away from growth and spending, because you can’t spend and pay down debt at the same time. You have to choose one or the other. The economy continues to grow at around 2%.
２）But China's economy is weakening.
The markets are under some stress because we have these global tensions. One of them is a policy divergence between the U.S. and the rest of the world, especially China which has an overvalued currency and a weakening economy. That has led to capital trying to leave the country, about $100 billion a month. So it’s a significant capital flight. In an effort to manage a devaluation in the Chinese currency, the yuan, China has to draw down on its foreign exchange reserves. That is a form of liquidity tightening, and that’s putting some strain on the markets.
３）Declining oil prices have shocked the system.
Oil prices have declined 75%, from $107 to about $26 a few weeks ago. Most people would say: “Well, isn’t that a good thing? That means that, essentially, everybody gets a tax cut in the U.S.” And that is true, but the U.S. went from essentially not being a player anymore in terms of oil production to being one of the biggest players in the world with this whole shale industry revolution. But that shale boom came with borrowed money—the high-yield corporate bond markets and bank credit lines. Now, however, oil is below the level at which anyone can make money, and there is a lot of distress in the energy sector, and that feeds into the credit markets, which feeds into the overall market. It feeds into the energy sector of the stock market, and that impacts earnings growth for the S&P 500. It also affects Brazil and Mexico and any country that is producing oil, especially at high marginal cost.
４）There's a disconnect between the markets and the Federal Reserve.
The fed funds futures curve shows what the stock market expects the Fed to do in terms of future rate hikes. And in recent weeks we’ve seen a dramatic rerating of what the market thinks the Fed is going to do. In December, the Fed was saying that it’s going to raise rates four times this year, and four times next year, until it gets to 3%. The markets have basically decided that that’s not going to happen. The markets don’t really expect a rate hike until sometime in 2017, so that’s a very dramatic shift.
５）Fundamentals need to turn around.
A healthy stock market rests on three pillars: earnings, valuation, and liquidity. You need rising earnings, you need reasonable valuation, and you need a supportive liquidity environment—low inflation, low interest rates, and low cost of credit.
We are basically one for three right now. I don’t think valuation is much of a problem, although some may disagree. The price/earnings ratio for the market is at 15 using forward earnings estimates. The range, historically, is around 10 to 20, so we’re right in the middle. So the market is not cheap but it’s not expensive either.
However, earnings growth has been coming down over the past year or so, at first because of energy, but now it has become more broad-based. For the market as a whole, earnings growth will likely be negative on 2015, and is expected to be up only a few percent in 2016.
And on top of that, the liquidity tide has been going out since the Federal Reserve ended quantitative easing in 2014. This has strengthened the dollar, and that has created stresses in emerging markets. As a result, foreign exchange reserve growth has contracted by about $1 trillion worldwide.
So those are two pillars that have not been supporting a rising market.
６）Corrections happen.
Corrections happen all the time. Using historical data since 1927, a correction of at least 10% has happened 33% of the time. So one-third of the time, the market was correcting at least 10%. On average, a bull market lasted 39 months. A bear market lasted 13 months. A bull market created a 77% price gain and a bear market produced a 27% decline. The entire cycle has typically been about 4.3 years long, and the market tended to advance 75% of the time. So those are pretty good odds.
For long-term investors, the key is to have a plan, and then stick with the plan. If your plan is the right one for you (meaning your asset mix is appropriate for where you are in life and for what your risk profile is), then it’s best to continue to dollar cost average into the market on an ongoing basis and to not panic when things get dicey.
(Edited from Fedelity Invastment)
