Three Lessons We Learned From a Volatile Quarter

The first quarter of 2016 draws to a close this week and it has been an interesting enough three months to make a retrospective justified. I rarely look back when writing in these pages: financial markets are about looking forwards, and have a tendency to repeatedly prove the old adage that the only thing we learn from history is that we do not learn from history. The panic that took hold at the beginning of the last quarter, however, is well worth analyzing, and doing so can teach investors three important lessons for the future.

There is a wonderful symmetry to the chart seen above for those last three months, with a pretty spectacular crash followed by a rapid recovery. From the safety of the mountain top on the right hand side of the chart, it is easy to look back into the valley and think “What were we thinking? What was all the panic about?” but at the time it felt to most people as if a major crash was upon us. Logically and with hindsight the drop was a buying opportunity and for those that track currency moves, even the bottom was somewhat predictable, but fear is a powerful thing.

What caused that fear were a few signs that a real global recession could be imminent. Europe was struggling and the ECB’s response was weak. Asia, led by continued relative weakness in China, looked stagnant, and oil, usually a good indicator of global economic strength, was falling to new lows. On top of all of that, the extremely high dollar in Q4 2015 led to a string of disappointing earnings reports from exporters and manufacturers. It looked as if the rest of the world’s woes were about to drag the U.S. down.

The response to oil’s weakness last quarter was particularly interesting, and led to a situation that, while absurd in theory, seemed to make sense at the time. Traditionally, oil weakness is seen as good for stocks outside that particular industry. Lower fuel and energy costs put more money in the pockets of consumers and decrease operating costs for businesses -- the ultimate win-win. Last quarter, however, the level of fear was such that traders convinced themselves that lower oil prices were bad for the stock market.

There was, I guess, some logic to it. The theory was that oil prices that low would lead to a whole rush of bankruptcies in the oil and gas industry, which in turn could cripple banks exposed to loans to those companies. What got ignored, along with the potential beneficial effects of lower oil, was that the extent of the total damage was pretty well known and confined to a relatively small number of financial institutions. The big boys could ride it out easily enough, and the smaller regional banks' problems, assuming they came, would not do any lasting damage to the system.

With the benefit of 20/20 hindsight, the panic overall was nonsensical. It was a reasonable bet that the ECB would eventually increase stimulus, Chinese growth may have been slower than anticipated but 6% is still decent growth, and the high dollar had already begun to correct itself by the end of January. As obvious as all of that seems now, the fear affected not only traders and investors, but also enough FOMC members for policy to shift. As speculation that that would be the case began to grow, so the market recovered.

So, what lessons can we take from all of this? First and foremost, as sad as it is in many ways, the stock market is still addicted to central bank help, whether it is the Fed, the ECB or the People’s Bank of China. At some point that has to come to an end, and that is when a major disruption will occur.

Secondly, selling based on fear rather than data is usually an opportunity to buy. Throughout all of this the hard data on the U.S. economy remained fairly positive. Unemployment was still falling, and growth, while not robust, was still grinding on at about 2 percent. Consumer wages and spending were likewise gradually climbing. All of that seemingly got pushed aside, however, as traders and analysts seized on any bad news and ignored the good.

Thirdly, as I have said many times here, if you want to be active in the stock market you need to understand other markets; forex, bonds, and commodities in particular. We live in an era of globalization and an understanding of the flows in global capital and its effects is essential if you want to predict future moves in the broad stock market. Once the dollar turned lower in late January, the effects could be predicted. A lower dollar pushes oil prices up and relieves the pressure on exporters in the U.S., pushing stocks higher.

The good news is that these three lessons are fairly clear. Watch the central banks, trust the data, and follow the currency. Predictions become a lot easier. The bad news, of course, is that all of these things have been obvious for a while but we still had that crazy volatility last quarter. It seems that we still don’t learn from history.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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