Market rollercoaster: should investors be spooked?

While the correction is severe, investors will know the rewards of enduring short-term turmoil

It has been a torrid week for global stock markets. Indices everywhere have been pummelled and volatility has gone through the roof on foot of mounting fears regarding the health of the Chinese economy. Should investors be spooked?

Clearly, many are. There has been carnage in China; eight other national stock markets, including Germany's, have fallen into bear markets (declines of 20 per cent); the FTSE and Nasdaq came within touching distance of bear market territory, while most indices have suffered double- digit corrections.

Market corrections are common, of course, but this has not been a run-of-the-mill pullback. It is often said markets take the escalator up and the elevator down, but the speed of the recent declines has been especially marked. Last week, the S&P 500 was just shy of all-time highs; at this week’s low point, just 5 per cent of stocks were trading above their 50-day average, something unseen since 2011.

The Vix, or “fear index”, briefly exceeded 50 on Monday – the highest reading in the index’s 25-year history, outside of the 2008-09 global financial crisis.

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Those of a nervous disposition might be glad to hear that during past market crises – the Asian financial crisis in 1997, the 1998 Russian rouble crisis, the 9/11 attacks in 2001, the European debt crisis in 2011 – readings in the high 40s marked a peak in volatility. Furthermore, Vix readings above 40 are associated with strong returns over the following three- and 12-month periods.

‘Inevitable implosion’

However, volatility does not diminish overnight; that the Vix has hit such heights indicates a truly high level of fear, so markets should remain nervy for some time to come. The extent of those nerves has been evident every day in what has been a rollercoaster week, with huge intra-day swings in stock prices.

While the huge falls on the Chinese stock market have dominated headlines, they should be of little concern to international investors. The Chinese market is a casino, a speculative haven dominated by retail investors. A demented equity bubble, one encouraged by authorities, developed late last year; as research consultancy Capital Economics notes, we are now simply witnessing its "inevitable implosion".

More worrying, as British fund manager Neil Woodford says, is China's "increasingly clumsy and apparently desperate attempts to stabilise the market", efforts that suggest it is extremely concerned over the true state of the economy.

International investors are focused on the potential fallout from a Chinese downturn. The fact that global policymakers appear almost out of ammunition – interest rates are already near zero in most developed countries – adds to these concerns.

Still, it’s not all bleak. Corporate earnings in Europe and Japan have been impressive; European valuations look relatively reasonable, with the Euro Stoxx 600 sporting a dividend yield of 4.3 per cent; cash levels are high among global fund managers, potentially boosting stocks if sentiment picks up.

Current conditions suggest a "very unpleasant" repricing rather than a prolonged bear market, says Mohammad El-Erian, chief economic adviser at Allianz. History supports this view. Eight of the last 10 US bear markets have been accompanied by recessions, according to JPMorgan research. Other triggers have included commodity spikes, aggressive interest rate hikes and extreme valuations.

One could argue none of these catalysts is evident today. Yes, US valuations certainly look rich relative to history, but it’s also true that sentiment has been decidedly muted in 2015. Stocks had been flat prior to the recent correction; global fund managers have been underweighting the US for six consecutive months; owners of US funds withdrew $78.8 billion in the first seven months of 2015, the most since 1993.

There is none of the investor froth that was obvious prior to the 1987 crash (stocks gained 40 per cent in the seven months leading up to the market top), or in 2000, when investors were piling into technology stocks.

Of course, a global bear market is a distinct possibility. If it does develop, it's likely to be a garden-variety bear market rather than another massive bust. Investors are still bruised by the memory of the 2008-09 and 2000-02 bear markets, when equity prices halved, but such meltdowns are the exception, not the rule. Second, current conditions are very different, judging by a global bear market checklist compiled by Citigroup.

Sell signals

Today’s markets satisfy five of 16 sell signals; that’s worrying compared with a year ago, when one warning sign was present, but things were worse in October 2007 (12 sell signals) and in March 2000 (15).

A garden-variety bear market might be of little consolation to someone about to cash in their pension, but it would be good news for most investors. After all, anyone drip-feeding money into their pension fund will be a net buyer of stocks over the coming decades. Investors get more for their money when prices are cheap; accordingly, they should be delighted when stocks go on sale, rather than cheering for higher prices.

Benefits of corrections

Investors’ instinctive loss-aversion blinds them to the benefits of corrections. It’s understandable investors shudder when recalling the trauma of 2008-09, but the severity of that bear market made possible the gains that followed over the next six years, a period that saw stock prices triple.

Now, it would be even better if we could sidestep corrections altogether, but timing the markets is fraught with danger. Most pullbacks do not become corrections; most corrections do not become bear markets; most bear markets do not morph into market meltdowns.

Some lucky souls do sell at the right time but miss out on the subsequent upswing, and little wonder: analysis of recession-induced bear markets show stocks typically rose by an average of 24 per cent before the recession actually ended.

Long-term investors are rewarded for taking risk and putting up with short-term turmoil. The coming weeks and months may be trying ones, but it's better to accept volatility than to avoid it. As money manager and blogger Ben Carlson said this week, corrections and crashes "are a feature of the financial markets, not a sign that they are broken".