The Worst Quarter in Four Years – and How to Make the Most of It

by Gavin Graham, Chief Strategy Officer October 08, 2015
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
The quarter that ended on 30th September, 2015 was the worst for global stock markets for four years, since the initial worries over the Greek crisis and the break-up of the Euro-zone drove down markets in 2011. US indices fell between 7.8% for the S&P500 and Nasdaq and 8.4% for the Dow Jones Industrials. The energy and materials (commodities) sectors both fell more than 18% between the end of June and the end of September and healthcare, hit by comments from presidential candidates condemning the high price of specialist drugs, ended down 11.8%. The S&P/TSX Composite fell 8.6%, dragged down by its high energy and commodities weighting, and the abrupt collapse at the end of the quarter in the share price of Valeant, its biggest pharmaceutical company, and, briefly its largest stock by market capitalization.

Elsewhere, the Eurostoxx 50 was down 9.5% and the UK FTSE100 7.1%, the Nikkei225 14.1% and the Shanghai Composite a remarkable 28.7% following the popping of the Chinese stock market bubble in June. Other emerging markets were also bad performers, as the concerns over weaker commodity prices, on which many emerging markets depend, and a stronger US dollar due to the falling likelihood of higher US interest rates, saw leading developing countries' markets decline rapidly. Of the other four BRIC (Brazil, Russia, India and China) countries, Brazil's Bovespa was off 15.1%, and Russia's RTS off 16%, with only India holding up relatively well, down 5.8%. Other major emerging markets like Indonesia, down 14%, and Thailand, off 10.2%, were joined in the losers' column by commodity exporters such as Australia, off 7.2%.

Furthermore, these end of quarter falls do not reflect the full extent of the damage, with many markets down over 20% in the last week of August from the end of June as concerns over China's unexpected though modest 3% devaluation of the yuan led to fears of currency wars. With lower liquidity in the summer, and an estimated three quarters of trading now being conducted by algorithmic programmes rather than by actual investors, the sharp falls experienced in July triggered many stop losses and trading programmes that followed existing trends exacerbated the speed and depth of the declines. On August 24th, for example, many major US stocks did not trade for the opening half hour and price movements were exceptionally volatile.

Assets regarded as safe havens, such as precious metals, also suffered during the sell-off, with gold falling 4.8% to close at U$1115 per oz. Only government bonds provided positive performance, with the Bloomberg US Treasury Index delivering a return of 2.6% for the quarter as the yield on the US 10 year Treasury bond fell back to 2%. Similarly the Bloomberg German Bund Index returned over 2% for the quarter, despite the concerns over the possible break- up of the Euro-zone due to a Greek exit (Grexit). Other major developed government bond markets also delivered positive returns, with Japanese and British bond indexes returning 1% and 4% respectively.

The other major factor that made many of the returns even worse from the point of view of a US dollar based investor was the sharp falls in most emerging market and commodity linked currencies, with the Brazilian real, South African rand and Australian dollar hitting multi year lows against the currency during the quarter. The Canadian dollar fell over 7% against the US dollar during the quarter as oil prices dropped back below U$50 per barrel and base metal prices fell to levels not seen since the Great Financial Crisis in 2008-09 on fears of lower Chinese demand.

The first and most obvious point that emerges from the events of the last three months is the importance of a maintaining a diversified asset allocation for investors, whether pension fund trustees or individuals. While the discipline of selling those assets which have risen in value to reinvest in those assets which have not risen as much, or have fallen is seemingly obvious, the temptation to keep "running your winners" is hard to resist. It is apparent that many investors chose not to rebalance portfolios to return them to the original asset mix which was suitable for their risk tolerance when bull markets are running hot, as was the case through the first half of 2015.

As a result, their exposure to less volatile income producing assets, such as bonds and cash, was lower than was suitable when unexpected events such as the collapse of the Chinese stock market in June and July and the yuan devaluation occurred. When added to the fall in energy and material prices, after a modest rebound in the first quarter, economically sensitive equities took fright at the potential of lower global GDP growth, exacerbated by political uncertainties such as the potential Grexit, Middle East conflicts and the immigrant crisis. With most markets selling at Price/Earnings multiples near the top end of long term ranges, as was the case in 2000 and 2007, there was little protection for investors when the selling began.

Investors and their advisors should ensure that their portfolios are run in a disciplined fashion and that the asset classes are rebalanced when the mix has moved out of line. However, the increasing volatility of global markets means that even investors who make use of the tax advantaged accounts available such as RRSPs in Canada and 401(k)s in the US, face the possibility of making contributions before a sudden downdraft, such as the one that has just occurred. While the benefits of dollar cost averaging, or making regular payments during the year to ensure that one buys fewer units when prices are high and more when prices are lower is well known, it can sometimes be difficult to follow when cash flows vary widely during the course of the year, as is often the case for incorporated individual businesses.

One of the advantages of the INTEGRIS Personal Pension Plan (PPP) is that it permits "make-up" contributions if the performance of the Defined Benefit (DB) option has not matched the return assumed by the CRA. This permits volatility such as been recently experienced to become a benefit rather than a negative, as it allows lump sum contributions to take advantage of the fall in the markets. Because a PPP also offers the flexibility to switch between the DB and Defined Contribution (DC) options at the beginning of each year, users can make use of the unused contribution room if they have elected for the minimum 1% contribution to the DC option the previous year, again allowing users to make large contributions at a time of their choosing and when markets may be more attractively valued.

While markets have undoubtedly suffered serious falls, and many are now down over 20% from their previous highs, which is regarded as constituting a bear market by many observers, it should not be forgotten that some markets are actually up over the last twelve months. China, the epicentre of concerns and identified as the cause of the sell-off in the third quarter, is still up 30% from a year ago and Japan's Nikkei is up 10%, while the German Dax and the CAC40 are both up 2% as is the Nasdaq, while the S&P500 is only down 1.5% and the EuroStoxx 3.5%.

While the S&P/TSX is down over 10% and the FTSE100 7%, their high resources exposure has contributed to their under-performance, and as noted, bonds have provided positive returns of around 4% over the last year. For a US dollar based investor, admittedly, the situation is much less attractive as the dollar's strength has reduced overseas returns by 10-25%, but Canadian investors have generally not suffered from currency movements due to the weakness of the loonie, and indeed have received a 20% boost from the strength of the US dollar for their US investments. Investors should not be discouraged by the exceptional volatility of the last few months. Stock markets that have been in a bull market phase for a long time, and this bull market began over 6 years ago in the second quarter of 2009, are subject to occasional violent sell-offs, especially when valuations have become extended. Investors should make sure their asset mix is well diversified, rebalance on a regular basis and make us of such vehicles as the PPP to give them the flexibility to take advantage of the opportunities offered by these pull backs.

Sources: Bloomberg, Globe and Mail - October 1st and 2nd?