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Understanding the current market environment

INSIGHT ARTICLE  | 

Understanding what has been driving the markets downward over the last few weeks

What do the words tumult, rout, tailspin and crisis all have in common? These are all words used in financial headlines over the last several days. These are also words we know make RSM US Wealth Management clients very nervous.

There are several underpinnings of the recent volatility and negative returns permeating global markets.

The obvious issue is China. According to RSM Chief Economist Joe Brusuelas, "It is becoming clear that the Chinese economy is experiencing a secular slowdown that will likely be accompanied by further devaluation of the yuan. The depreciation will likely be accompanied by much more robust action from Chinese fiscal and monetary authorities to avoid a hard landing for the economy, which is still reeling from overinvestment in housing, commercial real estate and manufacturing." The goal of the devaluation appeared to have the sole purpose of making Chinese goods cheaper and American exports more expensive thereby aiming to help their own economy. However, economists are also questioning whether the Chinese economy might actually be weaker than official government data suggests. The questions and issues with China are only exacerbated by the level of government intervention in its markets. Clearly the issues in China have sent shock waves through other global economies and currencies. Commodities have experienced major negative impacts as well, which would obviously see less demand from China during an economic slowdown.

Separately, the lingering and ongoing uncertainty about the possibility of a Fed increase in short term rates has many investors on edge. As we have written about many times before, the concern is less on the timing of an interest rate increase and more on its magnitude and speed. There remains tremendous debate over what investors think the Fed could or should do along with the implications of each move. With growing concern about global growth, the chances that the Fed will increase rates in September likely decrease with each additional day of volatility. As we now move into a period of volatility and market correction, a growing concern is over the lack of traditional policy responses (i.e. the Fed can't lower the Fed Funds rate below its current point at zero) from the Fed if the market volatility were to persist and the correction were to worsen.

According to Joe Brusuelas, "the churn in global asset classes appears closer to a panic about the underlying condition of the Chinese economy and financial markets than anything closely related to economic fundamentals. In fact forward looking investors would do well to remember that the Chinese character for crisis is the same as that for opportunity."

Understanding market volatility

What do the terms standard deviation, drawdown and VIX all have in common? These are all terms that can be used to describe risk and market volatility.

Standard deviation can generally be thought of as the volatility of returns. So let's put standard deviation into perspective. The following chart shows the standard deviation of the S&P 500 from January 1, 1975, through July 31, 2015, on a three year rolling basis. As can easily be seen, there have certainly been periods of higher volatility (1987, early 2000's and the Great Recession of 2008-2009). What is more surprising to us is not the level of volatility we have seen in the last few weeks but instead how little volatility we have witnessed over the last several years. Simply put, many investors have become complacent, assumed more risk that they likely should have and are now concerned with the most recent bout of volatility.

China Stock Market August 2015 - S&P 500 Rolling Standard Deviation

Similarly, the VIX, otherwise known as the "fear index" has spiked in recent days to levels we have not seen over a sustained period in years.

Understanding the drivers of return

In times like these it is best to get back to fundamentals. At RSM US Wealth Management, we believe there are six drivers of return: 1) time, 2) costs, 3) asset allocation, 4) investor behavior, 5) risk and 6) tax efficiency. Let's focus on a few of these.

Time: When we talk about time, we are referring to 'time in the markets' and not 'timing the markets'. Simply put, investors need to stay invested for the long term. Looking at the total U.S. stock market, returns have been positive 75 percent of the time during one-year calendar time frames since year- end 1925. Not surprisingly, the results improve to 88 percent positive returns when returns are viewed over five-year periods. Importantly, there has never been a fifteen-year period when U.S. stocks have had a negative return (this includes the Great Depression, the Great Recession and every other market from 1925). In other words, staying invested should lead to positive results over the long term.

China Stock Market August 2015 - investing

Asset allocation: Asset allocation, the decision of how much to allocate to various investments, is a major driver of portfolio performance and volatility. We believe strongly in a long-term strategic approach to asset allocation. We also believe that maintaining investment discipline, over time and through various market cycles, offers the best opportunity to achieve long-term wealth objectives.

Risk: Risk management is a critical component of any investment plan. There are two main aspects of risk we assess with each client: risk capacity and risk tolerance. Risk capacity is often described as a client's ability or need to take risk and examines factors such as goals, time frame and liquidity needs. Risk tolerance is often referred to as a client's willingness to take risk and examines more qualitative factors, like past investing experiences or personal beliefs about investing. The combination of both of these risk aspects is critical when creating an investment portfolio.

Investor behavior: Study after study shows that the average investor does a poor job of timing the market. Said differently, instead of buying low and selling high, the average investor tends to do the opposite. Many of these decisions are based on emotion. Rather than succumbing to emotions, we at RSM US Wealth Management believe it is better to create a plan for your future, discuss the possible scenarios that may happen and remain a patient and strategic investor. Remember, when the markets are the most depressed is the point of maximum financial opportunity (e.g. the S&P 500 has returned 20.3 percent on an annualized basis, or around double its historical average since March 1, 2009, just before the lowest point of the recession).

China Stock Market August 2015 - behavior

Understanding what actions can be taken during periods of market volatility

While we believe in a strategic approach to investing, there are still many actions that can be taken during a period of volatility.

From an overall asset allocation perspective, the RSM US Wealth Management investment team is continually evaluating their portfolio recommendations to make sure their underlying assumptions are still valid. Even though we wouldn't expect to make rash decisions, periods of volatility are good measuring sticks for validation of assumptions. From an investment standpoint, our team is also continually evaluating its recommended investments to ensure the managers are sticking to their stated investment disciplines and are not taking undue risks.

With current volatility, it is also an excellent time to look for rebalancing opportunities as well as harvest any recent losses for future benefit.

We believe managing your wealth is more than just managing money. It is about developing a personalized financial strategy that is as unique to you as your own signature. We understand your wealth represents security and freedom as well as responsibility and opportunity. Our advisors work with our clients to make sure their financial design matches their overall goals and objectives.

Please contact your RSM US Wealth Management advisor with any questions or comments.

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