Monday (August 5th, 2019) was a chaotic day for both the world economy and markets. We want to break down what’s happened, and how that will likely impact your investments. First off, both the Dow Jones Industrial Average and the S&P 500 Index were down a little bit less than 3% on Monday. This drop was largely driven by the US Treasury Department’s labeling of China as a currency manipulator, which has escalated the trade war between the US and China. There’s a lot going on here, so let’s take it apart.
The Investments are the Easy Part
Just like always, the investments are the easy part. Let’s start by putting Monday in perspective. It was certainly a bad day for the US markets. The S&P 500 was down 2.98% on the day, and the Dow Jones Industrial Average was down 2.90% (though you know what I think about the Dow). These are ugly numbers, but as you would expect, the media tried to sensationalize this by talking about how the Dow dropped nearly 770 points on the day (and usually focusing on the intraday trading where the Dow was down more than 800 points).
But let’s stick with the percent change (which is the right way to look at this stuff). Just how bad was Monday in the larger historical context?
It was bad.
Since 1950, Monday’s drop was the 108th worst day the S&P 500 Index has had. Or, to put it in terms that we can do something with, it was worse than 99.38% of all of the other trading days during that period. I think that qualifies as a bad day.
But it’s worth remembering that this is just one day. We know that daily moves are basically random – to the point that it’s really hard to tell them apart from a coin flip. But one of my favorite exercises to do after a rough day in the market is to compare the sum of all of the daily market movements over the past year to the total annual return over that same year. It’s a great reminder that for all of the market’s gyrations, things tend to smooth out.
Since the financial media normally talks about the days market movements in terms of how many points the Dow Jones Industrial Average moved that day, let’s follow their example here. From August 6, 2018, through August 5, 2019 the Dow was up 215.56 points (or up 0.85%). However, when you add up the absolute value of all of the daily moves that got us those 216 points, the number looks a little bit different. The sum of all of the daily moves was 43,168.33 points – more than 200 times what actually happened. We remember all of the wild swings because they are so vivid, but we don’t realize that it all sort of averaged out.
It’s also worth remembering that there’s always some crisis that is going to cause the market to come crashing down around our heads. Eventually the market will turn around, and some financial pundit will look really smart, but we are wired to be nervous about things that we can’t really control – which describes both the financial markets and the global economy pretty well.
Just in the past few years we were worried about Greece (and some other southern European countries) taking down the European economy. Then we had Black Monday when the Dow lost more than 3.5% of it’s value in one day. A few months later, China was about to crash and take the world economy with it. Later that summer came Brexit. Then we needed to worry about the start of a bear market because the market was too calm. And last year the Dow dropped more than 1,100 points in one day – it’s worst day ever in terms of points.
I don’t mean to suggest that we shouldn’t be worried about what’s going on. We’ve experienced one of the strongest bull markets ever, and eventually the markets will turn around. But it’s important to remember that there are always problems on the horizon.
What Will the Markets Do Next?
All of this is interesting, but the obvious next question is what should we do about it? What happens next?
As you might expect us to say, it’s hard to tell. We’re likely in for a good bit of volatility in the near term, but that is all that we really feel comfortable saying.
The VIX Index, which measures short-term expected volatility in the S&P 500 Index jumped considerably on Monday. In fact, it was the 16thbiggest daily increase the VIX has seen since 1990. But it wasn’t starting from a particularly high base. As of the close of Monday’s trading, the VIX was at 24.59, which is in the 18th percentile since 1990 – reasonably high, but not that high either.
But the important thing to remember is that we can’t really say which way that expected volatility will take us. The markets move based on what happens relative to what the markets expect to happen. It’s fair to say that the markets didn’t expect what happened today, but what matters is what happens next. It’s likely that whatever happens next isn’t going to be great for the global business community, but is it going to be better or worse than expectations?
Until we can answer that question, we need to stick to the basics. Just like always, stick to the basics. Focus on what you can control, and harvest the long-term returns that the market puts on offer.
But What Actually Happened?
The investments may be the easy part, but it’s important to understand what caused the market to, to use the technical term, freak out. The markets Monday drop was largely a reaction to the US declaring that China is a currency manipulator.
This is a symbolic move, as China does not meet the legal definition of a currency manipulator, and the only immediate effect of this declaration is that the US Treasury department is required to try and start negotiations with country’s labeled currency manipulators. Since we are already in negotiations with China, this does not have any legal effect, but it is likely to have some pretty significant practical effects.
The Trump administration claims that China has manipulated their currency by declining to continue propping up the Yuan. The administrations claim seems to have been triggered by the Yuan dropping below seven Yuan per Dollar. It is worth noting that the IMF has recently said that the Yuan is trading at levels that are consistent with the Chinese economy.
Why Does the Value of the Yuan Matter?
What impact does a cheaper Yuan have – why does this matter so much? Essentially, a cheaper Yuan makes Chinese goods more attractive to foreign consumers and foreign goods less attractive to Chinese consumers. This has the effect of partially negating the effects of the tariffs that are in place.
A good way to visualize this is to think about it in terms of people buying and selling goods. Let’s say that I’m buying electronics from a company in China. That company sets the price in Yuan, but I operate in Dollars. When I go to buy those electronics I have to change my dollars to Yuan, which I’ll then give to the company in China. Let’s think about what happens if the Yuan declines in value.
If the price of the electronics stays the same, then I can now buy those same electronics for fewer US Dollars. The Chinese company gets the same number of Yuan, but I spent fewer dollars to get the electronics that I wanted. Those goods became cheaper.
On the other side, Let’s say that another Chinese company wanted to buy soybeans from a farmer in the US. That farmer sets the price in Dollars, but the Chinese company operates in Yuan. The company will exchange their Yuan for US Dollars, and then pay for the soybeans. If the Yuan declines in value, and the price of soybeans in dollars stays the same, then it’s effectively more expensive for that Chinese company to buy the soybeans.
There are certainly other effects (and effects of those effects, etc), but this is the basic story. When a country’s currency gets cheaper it’s exports become more attractive, and imports into that country become more expensive.
So What Happens Now?
This is the million dollar question (well, actually a couple of orders of magnitude more than a million dollars).
On the trade front, hopefully China’s move to hold the Yuan steady will give everyone a breather and allow the negotiations to play out. If it doesn’t, we could be looking at another round of tariffs between China and the US, as well as potentially further currency moves.
On the investment front, what happened on Monday was the market incorporating all of the new information and resetting it’s expectations. While it’s certainly possible for the market to get surprised (like it was on Monday), unless we can predict how the future will square with what the markets expect then we can’t predict what the market will do in the short-term.
That “short-term” is important though. We may not know much about how the market will act in the short-term, but we have a pretty decent idea of how the market will act in the long-term – at least in outline. We want to take advantage of the risk and return relationships that are fundamental to how the markets operate. To do that, we need to stay disciplined and focus on the long-term – not the crisis of the day.
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