What is going on? Is it time to move to cash? The U.S. stock market has dropped over 10% in August, the Chinese "A" shares market has fallen close to 40% from its recent high and the other world markets are all wobbling. Market volatility (as measured by the VIX) has reached highs not seen since 2008.  The price of oil has dropped by over 50%, and the prices of gold, silver and copper are down as much from their highs. Is this deflation, a bear market, a worldwide recession, or a market tantrum due to the fact the Federal Reserve is likely to raise interest rates by a quarter of a point this month? Well..., it's a little bit of all of the above, but the good news is markets should calm down in a week because school's back in session! So don't panic, I'll explain what is going on, and you will see there is a silver lining.

First, let's talk about August. August is the month when the vast majority of the senior money managers who work in NY City (the epicenter of the World's financial markets) go on vacation. This leaves a lot of trading desks, the participants that make the market and facilitate trading activity, manned less experienced junior traders and dumb computers. That means when good stocks get sold at low prices there are less experienced traders with the authority to buy them and soak up the inventory, and the computers are programmed to just cut losses by selling when prices drop quickly. One of the things that has been unique about this market sell off is the lack of heavy selling volume. The price declines have occurred on light volume. The result is big price drops but without conviction because the buyers aren't there. Even with good stocks if there are no bidders some shares can trade at very low prices. As an example, assume 98% of those who own Apple stock think it is worth $180/share, and won't sell until they see that price. However there could be a seller who needs to get out of the stock at any price, and is willing to take $100. Well that is the price the stock will trade at. Even if it's only 2% of the supply of owners, until those sellers are gone or the money managers who know it is worth more come back from vacation.

Second, the end of the commodities super cycle has an effect on U.S. Treasury prices and stock prices. Oil is now trading at a price that makes its production unprofitable for many of the marginal providers that have been making so much of the oversupply in the last year. However, there are other geopolitical factors involved. When and if Iran is allowed to sell its oil, prices will continue to stay low longer than many of the commodity and arbitrage traders had calculated last spring. This has resulted in a lot of margin calls and forced selling to liquidate portfolios. If you borrowed on margin to buy oil at $60/bl., on the expectation that prices would recover to $80/bl. in 2016, the margin clerk at your friendly commodities broker will call you to put up more collateral (Treasures) when the price of oil drops to $40/bl. Since you can't sell oil below your cost you sell other things like stocks and buy U.S. Treasuries. See my February newsletter for a discussion about how this effects the U.S. Treasury market. The bottom line is that interest rates in the Treasury market are sending a false signal because the high demand for them is caused in part by falling commodities. Once commodity prices have stabilized and the hedgers and arbs are flushed out Treasury rates should start moving up in conjunction with the expectation that the Federal Reserve will start normalizing short term interest rates. Long bonds holders have gotten a short reprieve, but it won't last forever.  Remember that the value of bonds go down when interest rates go up.

Third, the energy sector made up large portion of the earning growth in the S&P 500 in 2012-2014, and these earnings have been cut in half over the last 4 quarters. However, earnings growth from the health care, technology and consumer cyclicals sectors have steadily made up for much of that decline. Earning growth drives the markets higher. The bottom line is that there has been a pause in the growth of earnings in the broad market while this rotation of where earning growth is coming from pushes through to move the overall market higher. The market will likely continue its sideways movement and seem volatile for a while before the second leg of economic expansion continues. My advice is to keep some cash on the sidelines as better entry prices come into line. Just keep collecting your dividends, buy a little here and there on the dips, and ignore the market's gyrations while it rebalances. Patience should pay off as I expect the second leg of the economic expansion to move the market higher later this year.

There are some indexes we think are good buys now. The broad S&P 500 at $1920 looks fairly valued relative to bonds, but on a risk adjusted basis it is still a bit overpriced, I think a safer entry point for the S&P is under 1800. Take a look at the VYM (Vanguard High Dividend Yield Index). Based on my risk adjusted model it is a firm buy all the way up to $65.50. Other ETFs which offer risk adjusted pockets of value are the VWO (Vanguard Emerging Markets ETF) up to $35.00 and the VSS (Vanguard International ex-US Small Cap index ETF) up to $93.00, and the VEU (Vanguard International ex-US large Cap index ETF) up to $44.50. Happy hunting.