Happy St. Patrick’s Day! We didn’t choose this day for a blog post because of the holiday, nor for the “official” start to March Madness (for fans of the Hoosiers and Irish, it began Tuesday and Wednesday…Go Big Red and Go Irish!). Truth be told, we’ve been waiting for clarity on this Ukraine War so that we could write with certainty and conviction.
The Russian invasion has been yet one more proof point that markets do not like uncertainty. It was notable early in the invasion that, on the days that the Russians were able to move troops swiftly toward Kyiv and other cities, the stock market bounced. This was because the end of conflict seemed not far off. Thus the likelihood of significant American involvement and the damage wrought by skyrocketing commodity prices (oil and European natural gas most pertinently) would be contained. As the conflict has dragged out thanks to the resilience of the Ukrainians, stocks have dropped.
We are not one to embrace virtue-signaling, corporate America’s latest infatuation, but we totally want with all our heart for the Ukrainians to send the Russians back with their tails between their legs. As for what I hope happens to Putin, compliance forbids me to say. All things are possible, but I think we’re all bracing for Putin to continue his campaign to destroy and pillage until he gets something negotiated out of it. Kind of like we’re all sort of wondering if another covid wave is in the offing.
So, no, we can’t provide any insight or wisdom into how the war will end, nor whether covid will return, nor how many times the Fed will raise the Fed Funds rate, as the long-awaited (and 1 ½ years too late) tightening cycle began yesterday. Does that make stocks uninvestable? Of course not. Every war is terrible, but most have a pretty limited impact on the U.S. economy and corporate profits. The world has been through numerous wars. In some the U.S. has lent moral support. In some we’ve provided humanitarian aid, or we’ve gotten involved via security, arms, and covert operations. In some cases, we have engaged the full might of our military. This is different in one major sense—that the aggressor is Russia. The longer the war is drawn out, the greater the odds that the West gets drawn into it, in spite of the nuclear threat. Obviously, the level of our involvement dictates the level of impact on our economy.
As has been widely reported, the economic sanctions have crippled Russia’s financial system in only a matter of weeks. Its stock market has been closed since February 25, although some funds that own Russian stocks continued to trade for another week thereafter, at declines that varied from -80% to -95%. Then the major global index providers like MSCI, FTSE Russell, and S&P Dow Jones kicked all Russian stocks out of their indices. Passive-managed funds which mirror those indices were forced to write down the value of the Russian stocks to 0, remove them from the funds, and set them “aside” somewhere (they can’t sell the stocks because there are no buyers). The impact on Russian bonds and the Russian currency (ruble) has been equally swift, with bonds marked down to 10 cents on the dollar (so, -90%) and the currency -50%. Nearly all Western companies have suspended operations in Russia. The country is starting to run out of certain foods and medical supplies already. Sanctions may not win the war, but they have ultimately united the West and crippled Russia. There is virtually no path for Russia to fully rejoin the world in normalized relationships as long as Putin is still alive.
The average Russian citizen is already suffering, through skyrocketing inflation, shortages, and job losses. Whether they blame the West or Putin is another story. Stories are rampant of Russians who have ties to people in the free world falling for the state’s propaganda. If they see images of bombed Ukrainian buildings and dead Ukrainians, they believe Ukraine is doing this to themselves to victimize Russia. A widely-quoted poll indicated 60% of Russians support the invasion. We pray that the hearts of Russians can see through to the truth.
Just as crazy as the impact of the Russian sanctions to Russia has been the impact to Chinese stocks. The MSCI China Index is down 45% from a year ago, and down 30% in just the last month. The downturn comes as China’s relationship with Russia faces a much brighter spotlight. Even when the government tries to disclaim support for the Putin regime, the market has reacted violently by selling Chinese stocks, ultimately calling the bluff of the CCP (Chinese Communist Party). In this way, the West, by way of the free markets, are essentially leveling sanctions on China. Not that we should expect an overthrow of the CCP anytime soon in favor of democracy, but the goal here is to prevent China from backstopping Russia in its sudden economic hardship.
The volatility in Chinese stocks calls into question the case for investing in China, and emerging markets which are at least in part manipulated by the state. You might be surprised to see that shareholders in Chinese stocks have now made almost no profits in 30 years. 30 years!? See for yourself:
And this despite the fact that the Chinese economy is 40 times larger now than then, as the second chart shows:
Okay, perhaps their stocks have been maligned unfairly, in terms of cheap valuation. The real proof is in corporate profits, right? Bad news: profits have risen from $4.62 per share to $5.97 per share in the MSCI China Index in 30 years. That’s an annual gain of less than 1%.
What has the S&P 500 done in 30 years? Even though we’re 10% off the highs, the S&P is up 961% in 30 years, not even including dividends. Emerging markets have long held obvious promise as millions of people progress from lower-income to middle-class thanks to higher wages and better jobs, and thus are able to consume more. Locally-operated companies usually have a leg up on the multinational competition given government rules that favor them. As these economies have become more globalized, it has been hoped that companies would be managed more like companies in the West, with more financial oversight and better leadership, which would ostensibly flow into profits. Finally, the play for emerging markets lately has been that they have much more exposure to commodities than developed markets, namely in mining, metals, and energy. Time will tell whether these play out in other countries, but in China, it would appear that the state is stealing profits at the expense of shareholders.
Before this blog post becomes a white paper on emerging markets, let’s look at our markets back home. You could probably forgive investors for being skittish in 2022, given the war, persistent inflation, the Fed starting to tighten monetary policy, and the +27% gain in the S&P last year. Before yesterday’s rally, the S&P 500 was sitting around levels of May/June, 2021, so we have given back only the gains of the 2nd half of 2021. But it has been wild within the markets. The unprofitable growth stocks which boomed in 2020 have seen accelerating losses. The epicenter of this investing style, the ARK Innovation Fund, is -56% just since November, 2021, and -43% year-to-date through Tuesday. This has been by far the worst place to be. Stocks like Peloton, Zoom, and DocuSign became poster children for the “new normal,” given that they are consumer-facing businesses, but are now starting to bring back memories of pets.com, or at least AOL. Primarily, they were simply overbought, and expectations for future growth became unrealistically high.
For every underperformer, there’s an outperformer, right? This year, it’s been value stocks (those with low valuations), dividend-paying stocks, domestic safety stocks (think Kroger), energy and commodity stocks, and defense contractors. As a group, our core stocks have outperformed all U.S. stock benchmarks this year, and the U.S. has outperformed the rest of the world. This is what we expect of our core stocks, to show up fully-clothed when the proverbial tide goes out.
As to whether the stock market has seen the lows for the year, it’s entirely possible, but we haven’t quite seen the typical shakeout, in terms of some of the technical figures monitored by Strategas (our economics research provider). The VIX (Volatility Index) usually shoots even higher, the put/call ratio hasn’t spiked, and we haven’t seen a massive “sell everything” trashing as is normal in a bear market. That said, the U.S. stock market is not in a bear market, just a correction, defined as a drop of between 10% and 20% from the high, so we may not get a complete bottoming process for that very reason. But we are cognizant of the fact that there are a lot of potential potholes and second effects out there, and that it’s a midterm election year. While Republicans reading this are undoubtedly salivating at their prospects for the midterms in Congress, midterm years are still typically pretty rocky. Also, we have found that years ending in “2” are as well, and that this rockiness is concentrated in the spring/summer years typically. Rockiness started early this year:
As midterm elections morph from uncertainty to certainty, markets typically rebound over the following 12 months, as this chart shows:
After the last midterm election in 2018, the 12-month gain into 11/6/19 was +12%, in spite of a very rough December, 2018. Speaking of rough, the meager gain after the 1986 midterms was “slightly” hampered by the inclusion of Black Monday, on 10/19/87.
You know we aren’t technicians, but this data reinforce two historical facts about investing in the stock market: usually stock prices rise over time (over 1 year, 5 years, 10 years…), but their volatility can be pretty stomach-churning at times. We have no reason to doubt that both will be true over the next 10 years.