Time to Revisit the Lows

SPX Index (S&P 500 Index) Daily 2016-02-09 10-26-28

You might be thinking that watching stock prices fall nearly everyday is starting to get old. We agree.  And here’s a reason to take some measure of satisfaction:  you’re actually right!  As you can see on the chart above, the S&P 500 continues to make round-trips down to this 1812-1860 range.  This is, in fact, the 4th time since last August that the market has plumbed these lows, only to bounce back up for awhile, fade back down to the lows, bounce again…. Even looking back at October, 2014, when the market fell 10%, it fell to these lows.  Now, if you’re a worrywart, you’d liken this to a drowning man coming up for air every so often, only to sink again.  To the optimist, though, it means that there are traders willing to jump in at those levels.

Before you get too optimistic, know that most other market indices have continually found new lows since last August. Small-caps, as measured by the Russell 2000, bottomed at 1104 last August, but have plummeted to 960 (that’s 14% below the old lows).  EAFE, which tracks all other developed markets outside the U.S. (like Europe, Japan, Australia, Canada), is now 9% below those lows.  Dow Transport stocks are 7% lower.  Even the Nasdaq took out new lows yesterday, 5% below the old lows.  The Dow Jones Industrials are the lone index above the August lows, even if only by 2%.

These things mean a lot more to short-term traders than to us. As much as we try to divine short-term moves in the market, we don’t count on our ability to do so when we make investment decisions.  We buy stocks and bonds which we are confident will be much higher in the long-term, and/or pay us back in dividends and interest along the way, and are priced such that they have little downside risk.

That said, we are very intrigued by the nature of this most recent market swoon.  In January, the worst stocks were the cyclicals, and especially commodity and energy stocks.  The market was held up by 3 kinds of stocks:  defensive, safe stocks (think J&J, Wal-Mart, Coke, P&G), safe yield stocks (utilities, telecoms), and growth stocks.  These days, growth stocks can be found mainly in two sectors:  technology and consumer discretionary.  Home Depot is a prime example of a consumer discretionary stock that had held up very well.  It has everything going for it:  very little exposure outside the U.S. (where economies are weaker and currencies are way weaker than the US$), exposure to rising consumer disposable incomes, exposure to a strengthening housing sector, and a history of 20%+ earnings growth in each of the last 6 years.

That was highly valued since corporate profit growth overall is hovering around 0%. Until 1 week ago.  In the last 5 trading days, HD lost 12%.  Witness also the stock performances of some other former highflyers:


Alphabet (Google)         -10%
Microsoft                         -10%
Facebook                         -13%
Salesforce.com               -21%
Amazon.com                  -23%
Tesla                                -24%

Hard to believe Microsoft was a highflyer, but it’s true! The stock had doubled in 2 years, up to its high at the end of 2015.  One more thing to note about this group of 6 stocks:  none reported any significant news in the last week, let alone any bad news.

At the same time that the growth stocks have been getting shot, safe stocks have continued to buoy the market in February. But they’ve been joined by some unusual allies:  stocks that had gotten shellacked the worst last year, namely commodity, industrial, and even some energy stocks.  In fact, the rotation out of growth stocks and into beaten-up stocks has been downright violent….on days like yesterday, there were a lot of stocks up more than 5%, and a lot of stocks down more than 5%.

This kind of rotation is part and parcel to every correction and bear market. It doesn’t necessarily mean it’s the end, but it does typically mark the beginning of the end, for what that’s worth.

The main concern for the market is still the hodgepodge of deleterious hypothetical side effects from the commodity and oil crash. Among these is the junk bond market, which has been a concern for awhile that’s getting more concerning.  Add to that new concerns among European banks, not only because of loan quality (emerging markets, oil companies), but because negative interest rates in Europe might permanently crimp their profits.  Some major bank stocks in the safest countries (Credit Suisse, Deutsche Bank) are now trading below their 2008 financial crisis lows!?

As for the economy, we still see no possible path to a recession this year in the U.S. With good wage growth and solid new jobs numbers almost certain to continue this year, we see growth in disposable personal income in the 4% range.  Assuming consumers don’t suddenly start to save all of that new income, consumer spending should be a solid contributor to GDP growth this year, probably in the +2% range.  Combined with a +0.8% contribution from government spending this year (thanks to higher spending and expanded tax cuts) gives you +2.8%.  It would be virtually impossible for capital spending, inventories, exports, and housing to gang up to contribute -2.8% to GDP, which would bring GDP growth to +0% (which is still not recessionary).  A dire case for all 3 of those would be contribution of -0.5%.

A recession in 2017 is more possible, given the likely lapse in government spending, but still, of the leading indicators we watch, which give us typically 1 ½ – 2 years lead time to a turn in the economy, none are flashing red. These include wage growth, monthly jobs added, unemployment filings, LEI indicators, ISM indicators, and the yield curve.  Based on how the stock market has been performing, you’d think that economic numbers are suddenly crashing.  But that has not been the case, even in Europe, where leading indicators have been steady and GDP growth actually starting to improve.  And don’t forget:  nearly all developed markets, including the U.S., are importers of commodities, and stand to see an economic boost from the crash in commodity prices.  Some pundits refer to it as the largest wealth transfer in the history of the world.

It is because of this simple fact that no U.S. recession has been preceded by a crash in commodity prices.  Generally there is a steep rise in commodity prices, but more importantly, a steep rise in wage inflation, which leads to a rise in inflation, and compels the Fed to raise rates (by far more than the 0.25% the Fed has raised rates this cycle).  Sure, maybe this cycle would be the first ever that the economy just peters out instead of booming and busting, but we wouldn’t bet on it.

We know that the economy and stock market are not the same, and that we could yet endure a bear market without a recession. However, we see way too much underlying support for stocks.  Mutual funds have already seen massive redemptions from stock mutual funds.  Sovereign wealth funds have already been liquidating stocks to help their countries fund budget deficits.  And stocks are now ridiculously undervalued compared to bonds.

The most intriguing investors right now are institutional investors, like pension funds and foundations, who have long since abandoned stocks in favor of hedge funds, and are now finding out how bad a mistake they made. Hedge fund returns in the 5 years 2011-15 averaged +2.3%, compared with +12.6% for the S&P 500.  Even treasury bonds earned +4.1% annually in that time!?  Yes, 2 ½ of those 5 years were good for stocks, and hedge funds are supposed to shine in bad stock markets.  Sadly, the -1.0% return from hedge funds in 2015 doesn’t exactly corroborate that objective.

With -1% hedge fund returns and +2% returns (best case) from bonds, how will pension plans meet their retiree payouts? How will charitable foundations meet their requirements to give away 5% in grants every year?  The rhetorical answer is to buy something that might generate a return higher than +5%.

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