Podcast 4th September 2015
Markets have a mindset of their own. At points of time, it will ignore all positives and focus on negatives and at other points of time it will focus on all positives and ignore negatives.
The recent volatility in markets is a case of markets focusing on negatives and ignoring positives. Equities have tanked with China leading the way with Shanghai Composite Index falling 50% from peaks seen in June 2015 followed by Sensex, Nifty, S&P 500 and German Dax with drops of 10% to 13% over the last few months. The sharp fall in global equities is due to worries of China’s economy slowing down leading to a global contagion where all other economies feel the pain of China slowdown.
The fact is that the pace of growth for China’s economy had come off over the last few years. GDP growth, which was in double-digit levels in the 2000-2010 decade, has fallen to levels of 7.5% to 8% over the last few years and forecast growth is at 7% and below. China’s slowdown has taken a toll on all commodity exporting economies including Australia, Brazil and Russia. Commodity indices are down over 50% from peaks seen in 2007. China economic growth worries was not new for the markets.
The markets had earlier focused on easy central bank liquidity and improving US economic growth with the US economy adding over 3 million jobs in 2014 and on track to add around the same this year. Given that equity markets were at record highs and credit spreads were at record lows for high yield US and Eurozone bonds, markets were looking for an opportunity to book profits and take money off the table.
China gave them this opportunity with its sharp fall in equity markets followed by devaluation of its currency.
What has changed for markets over the last few months? The Fed has been signaling rate hikes for a while and that has not changed. Economic data from US and Eurozone is coming in positive with US unemployment rate at eight year highs and Eurozone unemployment rate at three year highs. ECB and Bank of Japan are maintaining ultra loose monetary policies. Interest rates are at all time lows and inflation is nowhere in sight.
Once the current volatility subsides, markets will again look at positives and ignore negatives. This cycle will continue given the extraordinary liquidity infused by Central Banks and this liquidity will always search for returns.
Volatility is good for the market as it takes out excesses. Excess valuations, excess leverage and excess optimism are taken out when markets fall and when markets rise, excess pessimism and excess risk aversion is taken out.
Traders like volatility but the truth is most of them get burnt as trend changes. If you are building long term portfolios, you can afford to ignore this volatility but also use the volatility to weed out weak stocks from your radar that have risen due to pure speculation without any growth backing them.
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