Recent Market Volatility

The recent market volatility since the US Fed’s announcement of the reduction of its monthly stimulus program from this month has caused many to question whether we are approaching a down market cycle based on how well markets have risen since September 2011.

Since the Eurozone debt crisis of September 2011 Australian shares as measured by the ASX 100 have risen by 36% and global shares as measure by the largest 100 multi-national companies have risen by over 60%.

However the markets are concerned that the US economy is not strong enough at this stage to sustain current economic growth and recovery with tapering and (ultimately) removal of the US Fed’s stimulus program. And the markets are using the current US profit reporting season as an indicator of the strength of the US economy.

And the results have been mixed with negative results from the likes of Morgan Stanley with lower profit due to increased costs, IBM with weak sales due to reduced Chinese sales of server and storage infrastructure, and Samsung quarterly profit drop due to slower sales of smartphones.

On the other hand, Delta Airlines posted profit rises on revenue gains and lower fuel costs, Microsoft posted profit rise off the back off Office application sales, LG Electronics doubled quarterly profit off the back of TV sales, and Amazon posted a profit in 2013 on a jump in revenue.

If reporting season is not a good indicator of the markets then something can possibly be draw from economic developments.

From an economic perspective the growth and recovery story in developed markets remains strong with mainly positive data coming out of the US, Europe, and Japan. Emerging markets, on the other hand, are a concern as commentators are worried that a reduction of US Stimulus will stop the flow of capital that is flowing from the developed to the emerging economies such as China, Brazil, Russia, and other developing Asian nations. Commentators are looking closely at these economies to see if there are any similarities to the state of these economies just prior to the 1997-98 Asian Crisis where large flows of money out of Asian markets led to the collapse of the Thai currency and contributed to the Russian debt default in 1998. This is important as any vulnerability that is sensed by the market could lead to a sell-off in shares off the back of the strong gains that have been achieved over the last 2 years.

Luckily, emerging markets are stronger today with these economies largely having less debt (as a % of GDP), higher foreign currency reserves, lower inflation, and mainly floating (not fixed) and lower currencies. Of these economies China, South Korea, Taiwan, and Russia are less of a concern compared to Brazil, India, Indonesia, Ukraine, Turkey, and South Africa.

This all points to an environment of increased short-term volatility where negative economic or company news will send markets down on a day-to-day basis. However, from a fundamental point of view company reporting and economic data is mainly positive and supporting of current share prices that seem fair value based on Price to earnings ratios.