Sharp Selloff

In a matter of a week the stock market has gone from historically low volatility to historically high volatility. Through mid-August this year, the S&P 500 traded in about a 6% range. That changed last week when the index declined over 3% the first four days of the week, followed by another 3% decline on Friday and 4% more on Monday. This means that large cap stocks have lost 10% of their market value over the last six trading days. The damage to the average stock has been even worse, and if we measure off their highs, the median S&P 500 stock is down 18% as of Monday. Research firm BTIG tells us that, excluding bear markets, there have been only three times the S&P 500 has fallen by more than this in such a short period.

What caused this rout? China is being assigned the most blame, as their economy continues to disappoint, their stock market has crashed, and the authorities have begun to devalue the yuan, which seems to have thrown the financial world order out of balance. China’s managed economy relied for many years on fixed investment (physical assets such as land and buildings), which resulted in a misallocation of resources that it is now dealing with. It now faces the decision of whether to double down on its old policies or transition to a more consumer-driven economy. Either choice may be painful for them, and whichever one they make, there will likely be lots of money thrown at the problem, as seems to be the default policy prescription around the world these days. For centuries governments have felt compelled to manage their economies so that they may better serve us in the way that we think they should. China is just the latest example of the pitfalls of this approach.

The good news is that, in our estimation, the current events are not enough to throw the US economy into recession. Things can always be different this time, but the conditions that typically precede recessions are not present. And if we are not headed into recession, the recent downturn in the market appears to be unjustified.

The nature of a selloff can be quite informative as to its meaning or duration, and there are many signs that this correction may be ephemeral and that stocks may bounce back.

On Monday the Volatility Index (VIX), also known as the “fear index,” spiked above 50. The only time in the last 20 years that it has reached this level was in February 2009, which happened to be an excellent time to buy stocks.

AAII bullish investor sentiment has fallen to a level seen only a handful of times in the last 30 years. Each of those times proved to be a terrific time to buy stocks.

The CBOE put-call ratio hit an all-time (20+ years) high on Monday – another excellent contrarian signal.

Selling was relatively indiscriminate on Monday, indicating that much of it was “forced” selling, likely driven by liquidation of ETFs and futures contracts. If the selling were truly indicative of an adjustment to the assessment of US economic prospects, we would have expected greater differentiation in Monday’s trading, rather than defensive stocks declining as much or more than non-defensive ones.

We are starting to see research firms providing lists of stocks that are able to weather the global economic storms. This is normally what we see after the storm has passed.

As always there are no guarantees, but these are all very positive signs. We believe that once again those that keep their cool will be rewarded in the long run. We stay fully invested, as we believe it benefits our clients over the long run.

Best regards,
Mark Oelschlager, CFA
Co-Chief Investment Officer and Portfolio Manager
Oak Associates, ltd.

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