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Taking A Closer Look At The Market Downturn

After an indomitable six-year run by our domestic market, we saw the first considerable downturn in the U.S. since 2009 with the S&P 500 dropping by 6.26% and the Dow Jones Industrials by 6.57%. At the end of trading on August 18th the S&P 500 had been at 2096.92 but had dropped in value by 10.9% in just one week.

Since 2015 the S&P 500 had been trying to crack the 2150 mark, but to no avail. It remains to see how we will have to wait to see it hit that mark, although I would suggest that we might see that occur as soon as January 2016…

In the wake of this downturn though—and the hysteria surrounding it which had been perpetuated in the media and amplified due to the current presidential nominee process—there have been a multitude of opinions given explaining why it happened. Many of these had focused on China.

Since reaching its peak of 5178.19 in June of this year, the Shanghai Composite Index has collapsed in value (as of writing) by an incredible -38.20% in the space of just a few months. Having devalued the Yuan in an effort to pay back its creditors with inflated currency and undercut American exports to China, the distorted view of the Chinese markets—with highly misleading data propagated by the government—was seen as the mirage it was, with the result being a massive sell-off of assets. This even led to the Chinese government imposing a ban on the selling of shares to halt the market decline.

With this in mind, it should be no surprise that the financial climate in China was pinpointed as the catalyst for the downturn here in America as well.

A comparison between the S&P 500 and Shanghai Composite Index from the start of 2012 to the end of August 2015

As can be seen by the graph above, despite the similar woes in August, there is in fact very little correlation between the two indexes. The S&P 500 had been remarkably stable in its performance, especially in comparison to China.

Indeed, if the American and Chinese markets are so closely bound to one another then why when the Shanghai surged in value by 42.57% from the start of the year to the end of May did the S&P 500 only see modest growth of 2.36%?

Instead, it would be more accurate to suggest that volatility in China simply gave American investors the opportunity to sell of stocks which had become overvalued over the past six years and bring about a healthy correction in the market.

Media focus on China was highly saturated throughout August.

If China was then almost an arbitrary reason for the selling off of shares in the U.S., and an opportunity to reach a more realistic valuation of companies, then how could a downturn in the market have been anticipated?

After six years of consecutive gains for the S&P 500, some kind of downturn seemed likely in 2015. Only twice before had the U.S. market seen gains for six years straight: prior to the 1929 Wall Street Crash and before the dot-com bubble burst in 1999. A downturn seemed likely—although there was no way to guarantee it, one way or another—if not to the same extent as those two events.

Time spent forecasting the future performance of the S&P 500—looking ahead a year in time—using macro-economic indicators has certainly proven beneficial to us here at KAM. Our forecasts had consistently projected a downturn in the latter half of the year. We posted an article indicating as such as recently as back in April: Investing in a Bear Market.

We utilize multiple factors as part of our forecasts which all contribute to give us a sense of where the market may be heading. Similar to how certain characteristics of stocks tend to lead to outperformance—one of the core tenets of what we do here at Kruse Asset Management—there are various economic indicators which have a long-term, proven track record of predicting future market performance.

For example, just a couple of the factors that we take into account with our forecasts are the 10-2 Year Treasury Yield Spread (the difference between 10-Year Treasury Yield and the 2-Year Treasury Note Yield) and the CBOE Volatility Index.

Changes in the ^SPX, 10-2 Treasury Yield Spread and ^VIX since the start of 2015.

Again, despite some inverse correlation between the 10-2 Treasury Yield Spread and the ^VIX, the S&P 500 remains remarkably stable in comparison. However, it is in the influence of those factors on the S&P 500 in twelve months time that we are most interested in.

As can be seen below, our model predicts continued volatility in the year ahead but with an upward trajectory, based on what is happening right now in the economy.

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