What’s going on?

Shock horror.

Whilst talk of the biggest ever fall on the Dow Jones makes for good headlines, a 4.6% drop is far from a ‘crash’.

There was a 4.62% fall in August 2011, multiple 7%+ one-day falls in 2008, 7.18% in October 1997 and 22.61% in October 1987 – the latter we can call a crash!

That said, a 4.62% fall in one day is unnerving, especially when it follows a 2.5% fall from the previous trading day. Officially, a ‘correction’ is a reverse movement (usually negative) of 10% or more. One doesn’t expect 7.12% to come from just 2 trading days. And, at time of writing the Dow Futures are predicting a further 2.40% drop. Ergo, I think it’s safe to say we are experiencing a sharemarket correction.

Should you be worried?

I hope that if you are a personal client of mine you aren’t. This is the very reason cash is held as a separate investment holding in your portfolio; to limit any downside, and also to provide the opportunity to take advantage of any falls in price. Spare a thought for the majority of Australians who just keep their super/pension in a single diversified fund. The cash required to make pension payments, or pay insurance premiums/other fees, necessitates selling shares at a sub-optimal time. Whilst every client of mine sees the GFC as a distant memory, many Australians had irretrievable losses due to only being invested in a single diversified fund.  

Furthermore, as will be covered below, one of the main causes of this correction are bonds, and how they interact with interest rates. ‘Fixed interest’ sounds like a safe asset class, but it consists of bonds. Whilst conventional asset management states everyone should have a portion of their assets in fixed interest, there is a reason you have been in cash and suffering from those annoying term deposit renewal notices every 6 or 12 months. The GFC illustrated perfectly that bonds (fixed interest) are also volatile and can suffer falls. I don’t know what will transpire over the following days, weeks and months , but I am very glad my clients have virtually no exposure to fixed interest.

Again, as to the coming days, weeks and months … who knows? All I know is that despite the semi-regular market downturns, and the far-more-regular predictions of doom and gloom, share markets grow. And there has never been a correction/downturn/crash that hasn’t ended.  

What’s caused this?

First, the more I know about share-markets, the more I accept that crazy things happen – to this day, no one knows why the October 1987 crash occurred. What should be good news can lead to negative share movements and vice versa. This time, better than expected employment data from the US Bureau of Labor Statistics caused fears about inflation and interest rate rises. Though, you have to wonder why the quantitative easing “unwinding” didn’t give the markets the heads up on this, or why they couldn’t predict this as a likely outcome from the Trump tax cuts.

In the absence of a significant event such as a declaration of war, terrorist attack or natural disaster, it can be challenging to understand why markets move as they do, or why $60 billion has been taken from the Aussie market today.

Bonds

Bond prices generally move in the opposite direction of interest rates. In the US, there has been a long-term trend of falling interest rates since 1981; this therefore has increased bond prices.  It’s pretty clear that when interest rates scrape 0% in some places around the world, there is only one direction to go. Up.

With the US economy performing better than expected,  the ‘threat’ of more significant interest rate rises have caused bonds prices to fall significantly and their yields to increase. Bond yields can impact the share market in two ways.  First, investors may switch their money to bonds if the yields climb high enough – it is worth noting that Gottliebsen wrote in The Australian on the weekend that “Two-year bond yields have risen 70 per cent and now exceed share yields”. Second, higher interest rates make future earnings worth less, causing the value of shares to fall. 

A further concern with bonds is the decrease in bond values. It is estimated that the worldwide bond market is around US$82.2 trillion. If you combine all of the world share markets, you get US$65.6 trillion. Bonds are therefore significant, and if they were to crash in value, a lot of people are going to lose a lot of  money and the ramifications would likely spread to other asset classes. 

We do not know how deep this market dip will be, but we do know that it will end at some point. 

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