Quarterly Newsletter October 1, 2015

Why is it Called a Correction When it Feels So Wrong?

The correction is finally here! The moment investors and fund managers have been waiting for. Finally, they can put to work all that cash sitting on the sidelines. Hallelujah, happy days.
But first, have you ever stopped to ponder why the word “correction” is the chosen term to define a stock market that drops between 10% and 20% during a bull market? Who came up with that? The word has a real meaning too: “a change that rectifies an error or inaccuracy.”

If taken literally, this would imply that the correction is a good thing. The market must’ve been erroneously high before the correction. But when the correction ends, the market will ascend back to its old highs and then beyond to new highs. So, if the higher values before the correction were wrong, are the higher values after the correction wrong too? Are the only right values during the correction? If that’s the case, then why do we all just want to get the d**n thing over with and get back to wrong values? Maybe short sellers (who bet against the market) repurposed the word.

Whatever the case, most investors share the view that corrections (and bear markets) are painful. Even when they were preceded by massive gains in stocks. Let’s not forget that the market hasn’t endured a correction since 2011; typically the market goes only one year, not four, between corrections. The S&P 500 rose over 90% between those two corrections, and more than 200% from the bear market low in 2009. Might as well conclude we were due, although that conclusion doesn’t tell us anything about why the correction happened now. Nor does it provide any road map for where stocks will be going.

If you really want to try to think about the correction rationally, ponder this: if you were satisfied holding stocks at the beginning of 2015, you should be 10% more satisfied now, given that the market is 10% cheaper now. Or has your 2025 price target for the market changed? Are you concerned about the global economy, China, commodity prices, ISIS, Syrian refugees, Greece and the Fed? Okay, but if you’re trying to claim that these are highly predictable concerns looking out 10 years, then either you have a very good crystal ball or you’re fooling yourself.

How Did We Get Here?

We reached the high places of the market earlier this year thanks to a large pack of skeptical bulls. Never did you hear any outright bullishness. What changed over the last 4 years was that the bears went into hibernation. The doomsayers never went away, but the number of people interested in what they were selling shrank. Now the bears are back.

Money flows into mutual funds provide the proof of skepticism. Usually a year or two after the start of a bull market (2009 in this case), investors still on the sidelines start to put their cash back to work in stocks, because they see that the smoke has cleared. Not this time. Instead, the funds that fled from stocks during the financial crisis first went to cash and then into bond funds. From 2009 to 2012, AFTER THE BEAR MARKET ENDED, investors put $1.17 trillion into bond funds, and pulled more than $200 billion out of the stock market (as measured by U.S. equity mutual funds and ETFs). Here are the outflows from U.S. stocks each year, starting in 2009, in billions: $52, $41, $53, and $57. Yes, the most money came out in the 4th year of the bull market! These are shown on the next page. Then in 2013 the outflows reversed to inflows, and that $204 billion finally came back into stock funds. But normally 6 years into a bull market, a ton of money has cumulatively flooded into stocks, not $0. Let’s not forget that money naturally grows as wealth is created, as the economy expands, productivity grows, personal incomes rise, corporate earnings rise, and populations grow.

Why are we looking at mutual fund flows at all? Because they give us a very good, contrarian read on investor sentiment. Surveys of investors are good too, but we like to see how investors vote with their wallets. Check out the following table. The middle column shows the inflows (or outflows) to U.S. equity funds (mutual funds and ETFs combined). The right column shows the % return for the S&P 500 in the following year. So, you see in 2007 that $22.9 billion went into stock funds. The following year, 2008, stocks lost 37%. In 2008, $23.5 billion came out of stock funds. The following year, 2009, stocks gained 26.5%.

Equity Fund Flows vs. Stocks Return Next Year

Equity Fund Flows vs. Stocks Return Next Year

Being a contrarian sounds like a good idea, doesn’t it? Notice that the worse the inflows, the better is next year’s stock market performance. We ran a regression on these data series and it proved that fund flows are, in fact, a statistically significant predictor of forward market returns. In light of the inflows in 2013 and 2014, perhaps we should’ve become more bearish this year. Clearly we were a lot more focused on the fact that the cumulative 6-year inflows were $0 than the fact that the 2 years of inflows were actually pretty large.
So Have Investors Bought In?

Uh…no. Year-to-date outflows in 2015 have been -$91 billion. Larger than any year in recorded history. Nearly 4 times than what came out of the market in 2008, the worst bear market in 80 years.

Funds need to go somewhere….stocks, bonds, real estate, and cash are the largest destinations. If it comes out of stocks, it needs to go somewhere else. What if the U.S. economy continues to expand? Interest rates will probably rise. Do you think money will continue to flow into bonds as they drop in value? Actually, if you can stick with shorter-term bonds, you shouldn’t be hurt too badly by rising rates, but short-term bonds will get you roughly 2%, or 0% after inflation. Investors and savers need to be really scared to sacrifice their long-term savings plans in order to earn 0% after inflation.

Obviously, the stock market’s performance will depend upon the economy. Is a recession on the horizon? This economic cycle, now more than 6 years old, might seem long in the tooth simply given its age, but not if you consider how meager it’s been. As we’ve said ad nauseum in this cycle, it’s hard to crash a plane that hasn’t left the runway. A hot economy, on the other hand, invites speculative over-investment into industry. Such over-investment was seen in the 1990s in technology and in the 2000s in real estate. What part of our economy now has entered bubble land? We don’t see any sector as remotely over-invested in the U.S.

Commodity Bubble, R.I.P.

Leave it to Monarch, the “commodity experts,” to write about commodities. But seriously, the story of what’s happened to commodity markets is the story of the global economy, and by extension, global markets in 2015.

Bloomberg Commodity Index, 1991-2015
Bloomberg Commodity Index, 1991-2015


For those who hadn’t noticed, there was a commodity bubble which lasted roughly from 2002-2011. The above is a chart of the Bloomberg Commodity Index for the last 25 years. The bubble was impressive for its +160% gain in 6 years, followed by a sharp drop, then a sharp recovery into 2011. Some commodities had peak prices in 2011 that were well in excess of those in 2008, namely the metals and agricultural commodities. But the overall commodity index, which has a heavy weighting in energy, did not get back up to the 2008 levels. The bubble also had impressive range, as it gathered up pretty much every commodity. From oil and natural gas to precious metals to industrial metals to agriculture. Why? Demand was growing faster than supply. Producers had suffered years of purgatory in the 1990s and purged their productive capacity in order to survive. But in the 2000s, those who survived finally cashed in, as prices went nowhere but up. Demand was finally growing, and supply was having trouble keeping up. So, producers had the rare utopia of increasing both supply and price simultaneously. Those were the days.

At first, it was pretty easy to increase supply, because they could just utilize their capacity better. Like oil producers opening wells that they had previously capped. Or a copper mine hiring a few more workers to extract more. Or farmers taking their land out of conservation programs and actually farming it.

The next phase of increasing supply, however, is always a little more costly. Oil producers would need to find new areas to drill exploration wells to see if there’s oil. Miners would need to find new mines. And farmers would plant on imperfect soil, which requires higher costs in order to generate acceptable yields.

In the final phase of expansion, which took place in both 2007-08 and in 2010-11, producers were throwing tens of billions of dollars at single projects. Oil producers were drilling in places where there was zero infrastructure to get it out, such as Alberta, North Dakota, offshore Brazil, and the Arctic. Same goes for natural gas producers, with the biggest finds in places like offshore Indonesia and Australia, Siberia, and Pennsylvania. Iron and copper were being mined from mines so deep in the Australian Outback they required brand new infrastructure not only to get it out of the ground, but a humongous brand new port to get it out of the country. Farmers were irrigating, buying expensive seeds, and loading up on fertilizer to increase yields. These are natural reactions to high prices. Producers should have known, however, that at some point, the increased supply would overwhelm demand, and their profits would fall. Cycles don’t last forever. The best that a producer can do is to make the best of the good times, and NOT take on too much debt or permanently raise its cost structure too high.

Looking back, it’s just startling how much all these commodity markets had in common. You’d think that with totally different production methods, market structures, and catalysts for demand growth, there would be more dispersion. But no, pretty much everything found its low point in 2000-02, rose to great heights in early-mid 2008, plummeted, came back, peaked again in 2011-12, and has now sunk again. Tired of high beef prices? Even cattle, which has a notoriously long cycle and is greatly influenced by weather, has seen a drop of 23% over the last 12 months.

Commodity Boom/Bust
Commodity BoomBust


Even Sugar?!
Even SugarDoes your consumption of sugar change when its price goes up or down? We’re guessing it does not. Well guess what…even sugar is not immune to boom and bust. After bottoming in 2003 at 6c/pound, the price of raw sugar leapt to 32c by 2011 and has dropped by 68% since!
Are people eating less sugar? To the contrary, demand has continued to grow, at 3% in the last couple years. Granted this growth is not as fast as in previous years, but supply was the bigger story. Countries like Pakistan, India, Russia, and China greatly increased supply in 2009-12 in order to get their share of rising profits. Brazil, which produces 20% of the world’s sugar, would have too, but couldn’t because of droughts. We didn’t think there was a lot of arable land left in the world on which sugar could grow, but we were wrong. In fact, 72% of Brazil’s arable land is pasture, and 28% is planted crops; only 3% is sugarcane. Plus, improved cultivation globally has resulted in a 3% annual growth rate in yield. So increased yield + increased acreage = excess supply. And now, 80 of the 300 processing mills in Brazil have shut their doors because they lose money with sugar at 11c.

China is largely blamed for the crash in commodity prices, because they were the driving force for increased demand in the last 15 years for everything, and now demand growth is slowing for everything. Apartment buildings, skyscrapers, and commercial buildings are still being built, but not as many of them. People are still entering the middle class and are now able to afford modern conveniences. But not as many. They’re still buying cars, but not as many. At the margin, this change matters for the suppliers to those industries only because they had found a way to increase supply so much.

But the lost point is that demand is still growing for everything. Even oil. Global demand was growing at 1% prior to the oil price crash…and now is growing at nearly 2%! The fact that we’ve seen a demand response to lower prices indicates that the world economy may not be as bad as people fear. In the U.S., gasoline demand is now growing at 5-6%, after falling for 8 straight years. This is also playing out in Europe, which is an importer of commodities, and you’d think China would be benefiting too, because it’s a net importer of almost everything. One more problem, however, and this one is temporary: China (and who knows who else) was stockpiling inventories of everything, just to guarantee their supply. Now that we’ve entered an era of plenty, China is unwinding its inventories, which is exacerbating the supply problem.
The boom-bust commodity cycle harkens eerily back to the 1997-98 era. Commodity prices tumbled as global growth slowed, emerging market stocks crumbled, their currencies devalued, Europe was undergoing an identity crisis as it moved toward unification, and the U.S. dollar was king. The climax was in October, 1998, when the unfortunately named hedge fund colossus, Long-Term Capital Management, blew up. The U.S. economy was able to withstand all these exogenous global hits, as GDP kept growing 3-5% every quarter, and employment and wages grew strongly as well. Our stock market suffered a quick 10% drop in October, 1997 (eerily similar to last October’s 9.5% drop), followed by a 20% drop in August-October, 1998. From there, the market went up another 60% to the peak in March, 2000.

A lot of similarities to today! Real-time data in the past few months shows the U.S. economy has been resilient. The Brazilian real has fallen 61% to the dollar, the Russian ruble 58%, and pretty much every other emerging market currency is down more than 25%. Have we already seen the worst? Or will there need to be real blood in the streets…like a country defaulting on its debt? This is gut-check time for emerging markets; those who took on too much debt, made generous promises to retirees, rely too much on commodity sales, or are government-run states will be tested. The choices for many will likely come down to austerity, reforms, or default. Venezuela and Argentina, we’re looking at you. Others have made much-needed reforms to budgets, debt, and government meddling, and they should manage the transition well.

One big difference between 1998 and now is that our economy is not quite as strong as it was then, so it’s a dubious proposition that the U.S. can pull up every other country with our consumption growth alone. Especially when we’re importing less oil. But Europe is on the mend and Japan might be too. While the global economy is looking iffy, and the U.S. does trade a lot of stuff with the world, know 2 things:

1) The U.S. is more insulated from global issues than any other country or region of the world
2) The U.S. is a huge beneficiary of lower commodity prices, because we’re a net importer

Employment is still growing at the perfect rate (1-2%), wages are growing at a perfect rate (2-3%), housing is starting to add to the economy, car sales are very robust, the budget deficit is shrinking, and the consumer has more to spend because of lower energy prices. Now if we can get steak prices down, that would seriously release the consumer’s “animal spirits!”

It’s really hard to be bullish on commodity prices going forward. Producers have created a huge amount of slack capacity which is now off the market but can be put back on the market when prices rise. That will prevent prices from rising much. There’s plenty more copper, iron ore, oil, and gas in the ground that producers identified but isn’t economical to extract at these prices.

But don’t forget that throughput is now actually growing faster. Industrial companies with exposure to the energy sector have performed horribly this year, as the energy sector defers capital projects, and applies price pressure to suppliers. But that price pressure will start to dissipate in the 4th quarter, and become minimal by next year, at the same time that demand is still growing. There are so many really cheap industrials, it’s almost like shooting fish in a barrel.

In short, if you wanted to summarize this tome into 1 sentence it would be: the market got complacent, China’s economy slowed, commodity prices crashed, the bears returned and raided the stock market. In aeronautical terms, we hit an air pocket. It feels turbulent, but we don’t see a storm in the U.S. economy. We don’t know when the correction will end, or at what level, but 3 factors are making it seem like we’re near the end. First, mid-October typically marks the end of most corrections. There is no intrinsic reason for this, other than it’s become a self-fulfilling prophecy. Second, the market is following a tried-and-true pattern of a violent drop (on 8/24), a recovery, a fade, and a re-test of the original low. The market is now in the re-test phase, with way lower volatility than on 8/24. Finally, the sector that had been performing best, biotech, finally got shot, and is now down almost 30% from its high in July. Rotation out of winners and into losers is part and parcel to every correction. Plus, the market hasn’t had a losing year in the 3rd year of an election cycle since 1939!

Yes, the economy will eventually erode into a recession, but every recession is preceded by a hot economy: wage growth over 4%, higher inflation, a tightening Fed, and an inverted yield curve. We’re nowhere close to any of these. It might be 2 years to a recession, IF our economy strengthens a lot, but if it doesn’t, the Goldilocks economy (not too hot, not too cold) might be alive and well beyond that. If you buy into no recession, then it’s a good time to buy stocks. If you just want to keep the stocks you have, that’s good too, because there are plenty of investors panicking and doing the only tried and true method of wrecking your long-term performance: changing investment strategy in the middle of a bad stock market. The chief investment strategist of Edward Jones described how “investors” react to their stocks going down: “they sell everything and then figure out what things they shouldn’t have sold.” Nice strategy!

Written by John Meyer