Market Correction — October 2015

October 28, 2015

Dow Jones Average: 17,581
S&P 500 Index: 2,066

Market Correction

The U.S. stock market went for almost four years without a price correction, defined as a drop of at least ten percent from a market high point. The recent sell-off in August and September of about twelve percent qualified as the first price correction since October 2011. As markets climb ever higher, so do worries about a catastrophic fall. It is just natural for humans to be afraid of heights. The tension that accompanies high markets is typically relieved by short bursts of selling, some of which qualify as full corrections. But with no good alternatives to stocks in a zero percent rate environment, investors have been extremely reluctant to part with their holdings in recent years. It took a confluence of factors, including the huge fall in Chinese stocks earlier in the summer, destabilizing moves in currency markets, concerns about an interest rate hike by the Fed, and a persistent decline in the energy sector, to finally raise the anxiety level to a point where investors started to sell stocks across the board.

The decline in stock prices, which was initially modest, gained momentum as key support levels gave way. In volatile trading sessions, reminiscent of 2008, the Dow Jones Average suffered a string of 200 and 300 point down days. This got the attention of individual investors who had come to expect rising, low volatility markets. Just as individuals were beginning to lose their nerve, the computers suddenly kicked into high gear on the morning of August 24, 2015, causing the second flash crash in the past five years. A flash crash can be defined as a quick (as in minutes), huge move in stock prices, disconnected from any business reality. The massive volume of shares transacted, a drop of over 1000 points in the Dow, and the bizarre pricing of stocks that occurred between 9:32 and 9:35 AM on August 24th, had to be driven by high-speed computers following certain algorithms. When the computers take over and a flash crash occurs there is not much a human can do, except watch the fireworks. On the morning of August 24th normal trading ceased, circuit breakers designed to prevent a 1987 style crash (down 22% in one day) kicked in, trading was halted in over 1200 stocks, and the bid/ask prices on many others were nonsensical. The nature of a flash crash makes it a somewhat unnerving and untradeable spectacle.

Markets generally recover from corrections fairly quickly, unless the correction turns into a protracted, bear market. After a difficult third quarter, the stock market did firm up in October, thanks to some decent earnings reports. The recovery in share prices has been uneven, with most of the gains accruing to a small cadre of technology companies. While the gains in a few technology companies have been notable, diversified portfolios are likely to hold a mixture of winners and losers in the aftermath of the third quarter correction.

Current Strategy

Even though the major market indices have technically recovered much of the ground lost in the recent correction, many financial commentators have referred to 2015 as a rolling bear market. There have been significant price declines in many sectors of the market, occurring in a staggered or rolling fashion. A strong Dollar combined with weak economic conditions in China has pummeled energy and other commodity stocks all year. Industrial companies that supply the energy industry or global infrastructure projects have been similarly affected. Retail stocks have been a minefield, as evidenced by an historic drop in Walmart shares, and a disastrous year for retailers of teen apparel. The medical sector, which had been one of the market stalwarts, has come under pressure recently as high medical prices have become fodder for political debate. With so many market components under pressure, the substantial recovery in the indices is a bit surprising. The markets have become bifurcated, with gains in tech offsetting losses elsewhere. Even within the tech sector most of the gains have accrued to a handful of companies. Such concentration of market value is typically not a good foundation for further progress.

We had a somewhat cautious allocation to equities going into the market correction, which seemed appropriate given the historically high market level. While everything in our typical portfolio went down during the market decline, the modest allocation to stocks buffered the fall in overall account size. We are maintaining a blend of stocks that includes stable companies which pay large dividends, companies with modest growth and dividend profiles, and companies that are pure growth vehicles without dividends. In recent months investors have been pouring into the pure growth companies, while shunning many of the larger dividend payers. Even though investors seem to be enamored with one type of company at the moment, we intend to stay with a blend of stocks that can benefit portfolios in different ways over time.

We have been more active on the fixed income front over the past few months. We purchased some tax-exempt municipal paper when rates rose on expectation of the first Fed rate increase in eight years. The timing of the buys looks good in retrospect, as the Fed decided once again not to raise rates. For the first time in many years we bought some corporate bonds that yield between three and four percent, a rate that is almost double the treasury yield for similar maturities. The corporate bonds carry some risk associated with pending mergers or shareholder activism, but we think the companies will be able to easily pay the interest and principal on the bonds.

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