Causes Of Market Volatility
Correlations between equity markets globally, as well as correlations between different asset classes like equities and bonds or commodities, have been high and rising in recent years. Such high correlations are not normal and have occurred despite significant deviations in the economic growth path of countries.
Economic growth is important when analysing potential asset class returns since company earnings are geared to positive economic activity. Over the long term, growth in earnings should translate into growth in the fair value of shares. But shorter-term market moves are usually the result of factors other than longer-term earnings growth.
Since reaching a peak of over 52 000 in August, the SA market declined below 50 000 in a short space of time and has experienced significant volatility subsequently. In this article, I identify four factors that explain the market's recent volatility. As fund managers, we should determine whether these factors will have permanency. If we conclude they are short-term aberrations, we may use the opportunity of cheaper prices to increase the weighting to equities in our portfolios.
After the global financial crisis, central banks have been quick to use non-traditional tools, like quantitative easing, to support economic activity. The abundance of cheap money, ultimately intended for businesses and consumers, has provided an almost permanent source of capital for financial markets. However, the US Federal Reserve has now concluded its bond purchase program. As those bonds mature in the coming months and years, the additional liquidity will be stripped from the financial system. Buyers of shares outstripped sellers for some time, but the tide is turning. Continuing European Central Bank and Bank of Japan stimulus may delay the process, but not indefinitely.
Many years of ultra-low interest rates have caused market participants to allocate capital to relatively high dividend yielding shares. Federal Reserve guidance shows that US interest rates may rise earlier originally anticipated. Rising interest rates will be negative for share markets, especially those that benefitted most from the preceding period of low and falling rates. This group includes many emerging markets, as well as the JSE.
In the past five years, equity markets (including the JSE) have risen faster than the earnings of their constituent companies. This is known as price-earnings (PE) expansion or a market re-rating. Higher PE multiples dilute future return prospects. Therefore, the decision to invest in equities at higher PE's is riskier. Investors with short investment horizons may sell to take profits. These factors may compound the negative market momentum if investors lose confidence in future return prospects.
Changing earnings growth expectations is an important short-term driver of share prices. Upward earnings revisions are positive for prices, while the contrary holds for negative reversion cycles. Valuations on the JSE exhibit elevated expectations for earnings growth for the market as a whole. In our view, this is largely attributable to overly-optimistic earnings forecasts for the resource sector, which has a high risk of negative earnings surprises. This would be negative for the share prices of these commodity companies and thus the resource-heavy market index.
In summary, the four indicators analysed above point to a more circumspect period ahead for equity market investors. As long-term, value-oriented investors, we are particularly excited – market volatility gives us a rare opportunity to buy quality assets for our investors at significantly reduced prices.
Director: Foord Asset Management