Market volatility has increased dramatically in the early days of 2016. Most of the gains of the fourth quarter of last year have been erased in the first two weeks of the New Year. Emotional selling has driven the stock market down 6.0% in the past seven days alone. What is causing the market to decline? Markets hate uncertainty and there are a number of question marks impacting the financial markets at this time.
The first uncertainty relates to slowing economic growth and declining stock prices in China. Economists fear that slowing growth in China will eventually spill over into the developed world at a time when central banks are limited as to the policy responses available to combat weak economic activity. The decline in Chinese stock prices are less a reflection of economic conditions and more a reflection of the inefficiency of a market that has only recently been open to foreign capital inflows. The lack of foreign investment and strict state control measures limit liquidity in the Chinese capital markets and contribute to wide swings in stock prices.
Commodity price declines also have investors worried. Declining demand from China, a stronger U. S. dollar, and an increase in supplies have contributed to deteriorating prices. Investors have interpreted this to be an early warning sign of reduced manufacturing activity which will eventually lead to a decline in global growth. Declining global growth could negatively impact corporate profits and stock prices.
Stock market valuations are at above average levels at the same time that corporate earnings expectations are contracting, further contributing to volatility. For several years, companies have generally been reporting weaker than anticipated sales, but have met net earnings numbers through accounting changes, share buy-backs, tax deferrals, or expense control measures. The one time nature of these methods has caused analysts to reduce earnings expectations for 2016. The recent stock market decline is partially due to these reduced earnings expectations.
While the recent volatility has been painful, we always encourage clients to take a longer term view of the markets and the domestic economy. At this time, we believe that the U. S. economy will continue to grow at a slow but sustainable pace this year. This should produce positive corporate profit growth that, when coupled with the very low level of interest rates, will support stock market valuations and prices. In addition, our investment process focuses on high quality and conservatively financed companies. These types of companies are favored by investors during periods of uncertainty. We want to encourage clients to maintain commitments to equities. Decisions to sell or dramatically alter asset allocations during emotional times rarely produce positive outcomes. We will continue to monitor ongoing developments and keep you apprised of any changes in our position.
Please contact your wealth advisor for further insight regarding our economic and market outlook.
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