Market Volatility Update

Our blog post last Friday focused on the return of volatility to the equity markets. This past week has seen volatility increase amid market declines. On Wednesday, we distributed our thoughts on this continued volatility to clients and friends. Our thoughts are reproduced below:

On Friday, we posted a blog post on our website addressing the recent market volatility. In the past few days, the markets have continued to be volatile, with the VIX (a measure of market volatility) at ~ 40, a level not seen in over two years. Equity markets are approaching 10% correction territory.

There are several causes for the market correction.

First, crude oil prices have declined significantly in a little over three months, due to a stronger U.S. dollar and concerns about global economic growth. The speed of this decline has rattled the energy sector. While OPEC (led by the Saudis) typically has supported oil prices by cutting production when necessary, it appears that the Saudis are now content to let oil decline in the short-term in an attempt to squeeze profits for U.S. fracking companies and Iranian oil producers. However, oil prices, like any commodity, are highly cyclical and volatile. We strongly believe that during our 3-5 year outlook, oil prices will recover, whether because of lower production or higher demand from the world economy. Even in the short-term, the decline in oil is not necessarily a negative, as lower prices at the pump often act as a tax cut and are a boost to the wallet of the U.S. consumer.

Second, growth in the European Union remains stagnant, as it has been for years. The question is why this slow growth overseas is such a concern now. One reason is that the German economy – long the driver of E.U. growth even during this slow period – is approaching recession territory. Germany appears to be taking the brunt of Russian economic sanctions. The E.U. governments also are showing increasing signs of disharmony over how to address their economic problems, and the European Central Bank has less weapons at its disposal than the U.S. Federal Reserve to address these problems. Notably, unconventional monetary stimulus in the E.U. (like the Fed’s quantitative easing program) faces strong opposition from Germany. We believe there is no question the weakness of E.U. economies are a headwind to U.S. growth. But, this is nothing new. We take into account concerns about E.U. growth in valuing potential investments, but do not see these concerns as a reason to sell out of U.S. equities.

Finally, we have been anticipating a 10% correction for more than a year now. The speed and suddenness of this correction may be jarring, but it is not unexpected as market psychology can turn negative in a very short time. Ultimately, 10% corrections are necessary to sustain bull markets over several years, as prices consolidate before another leg up. U.S. equities have seen on average two 5% or greater corrections each year during the economic recovery of the past five years. Most importantly, we do not view a U.S. recession, and corresponding bear market, as being on the horizon in the near to midterm, given current very low interest rates, low inflation, and moderate GDP growth.

At RDM Capital, we never make investment decisions out of panic when the markets decline as they have in the past few weeks. With our long term investment horizon, we view volatility and temporary market declines as opportunities to buy securities of companies that possess strong fundamentals and are poised for success over the long run. We are selectively buying equities that we view as oversold and with fundamentals that suggest they will outperform.