Newsletter: February 2016


Newsletter: February 2016

As we move into February, there is a fierce tug-of-war between market participants who believe the recent sharp selloff over the past 30 days is a precursor to much rougher times ahead and those who believe the decline is just another garden variety temporary scare. It is true that every significant economic slowdown (i.e. recession) is accompanied by a sharp market selloff.  But, not every market downturn leads to recession. This month’s market decline marks the third consecutive down-January performance.  Both in 2014 and 2015, investors suffered first-month losses and had to endure high volatility.  2014 ended the year with nice gains thanks to a last minute Santa Claus Rally:  Last year Santa, Rudolph, and his fellow Reindeer decided to skip the traditional Christmas lift-off.  

As a leading indicator (predictor) of future economic activity, many market followers assume the market “knows something” we do not. The U.S. stock market is a reasonably good barometer and predictor of future economic activity – but it is not infallible. One needs to be careful about automatically assuming that a market downturn will lead to a recession.  More times than not it is just a market selloff – that is it.  Examples we have experienced include the 1987 stock market crash and the 1990 Asian Currency crisis.  In both circumstances the markets dropped over -25% only to bounce back within 12 months.  Remember the late Nobel Prize winning economist Paul Samuelson’s observation– “the market has predicted 9 of the last 5 recessions.”

Long-time Wall Street strategist Byron Wien pinned one of our all-time favorite quotes, which we have returned to over and over again for the past 30 years.  It reads: “Disasters have a way of not happening.”

This quote seems especially relevant today given the heightened sense of uncertainty and fear.  It is tough to keep one’s composure when bombarded with constant and unending gloomy economic predictions where so-called experts implore, with such self-confidence, that investors should sell all their mutual funds/securities and move to the safety of cash. Internet trading services which tabulate speeches and word/phrase searches have noted a very high # of hits to words like bear market, recession, and such.  In the midst of every selloff, the perma-bears come out of their caves and hibernation to make dire predictions.  It is usually the same cast of characters – all of whom must have had terrible childhoods.

Judging by the mutual fund inflow/outflow data it looks like many investors are following their advice.  Over the past 52 weeks investors have sold a staggering $130 billion of their mutual funds/ETFs with $11 billion liquidated in the past 7 days.  This doubled the 2009 totals, which marked the bottom of the severe bear market.

This selloff is following the pattern/cycle of past meltdowns – bad news hits, people sell, which leads to more selling, which leads to panic, and so on.  We get this “snowball effect” where actions compound one another, leading to a selling stampede – kind of a 2+2=5 mathematical equation.  We hit a crescendo of selling last Wednesday, where the large mutual fund families reported one of their single highest redemption days in seven years. Our bigger concern is that the “herd behavior” makes things a lot worse via the negative wealth impact (when asset prices drop you feel poorer – so you spend less). 

Market participant fear is totally understandable.  We have serious economic, political, and geopolitical problems.  And our two political parties have leading candidates who express vastly different views and solutions, especially around government intervention, new regulations, income/wealth inequity, etc.

We suspect that much of the extreme market volatility has more to do with minute-to-minute quants, hedge funds, and risk parity traders who care little about the underlying fundamentals and/or corporate balance sheets and earnings.  Their minute-to-minute buying and selling has nothing to do with value.  Many market observers feel the quants need to be killed before they kill us.

The market internal #s are terrible.  Last Wednesday, over 45% of the NYSE issues were trading at 52-week price lows and over 70% of all listed stocks were down 30% or more from their highs – a level reached only four times in the past 30 years. In 2015 the average stock was down over 11% with 50% of all stocks down -20% or more. For the 21 days following the 12/15/16 FED interest rate bump of 0.25% (one quarter of 1%), the market shed approximately 12% of value. In our view, most stocks have already priced in a severe economic downturn.

The general domestic economic news has been underwhelming.  On Friday, the Commerce Department released 4th Quarter 2015 GDP #s registering a 0.7% expansion rate.  In addition, new orders for durable goods (computers, airliners, appliances, etc.) fell -5.1% in December – the worst decline since 2009.  Consumer spending, which makes up two-thirds of our country’s total economic activity grew at +2.2% annualized pace – less than expected but not terrible.  One would think lower oil prices (i.e. more $ in our pockets) would result in a pickup in consumer spending.  One area definitely experiencing a recession (or worse) is  the manufacturing sector.  If you do not believe me, take a weekend drive to my hometown Longview-Kelso and take a look at the economic landscape – not a pretty site.  Fortunately, manufacturing makes up less than 12% of our total domestic economy (services make up 86%). The good news is that, for now, oil prices seemed to have stopped their steep decline and have stabilized around $30/barrel. It is disappointing that our economy is growing at a sub-par 2.5% annual clip.  And this follows seven years of basically zero percent interest rates, close to $4 trillion of money printing, and $6 trillion of additional public debt.

The high-yield bond market is very uneasy with the spread between investment grade and non-investment grade bonds reaching over +8% and S&P predicting a 9% high yield default rate this year.  S&P downgraded 165 bond issues in the 4th quarter alone, the highest since 2009.

There seems to be a huge divide between what the Federal Reserve is seeing and what the markets are saying – basically there is a disconnect on why the FED would be raising rates (and telegraphing 4 more rate hikes this year) when both the domestic and global economies are slowing.  An out-of-step FED creates much investor angst.  In the end, we believe the FED will blink and take their foot off the rate gas pedal.​

This leads us to the next question – “If you take out the oil price plunge, slowing China, and Middle East problems, has the news really been that bad?”

We are smack-dab in the middle of earnings season.  For the 40% of the companies in the S&P 500, 69% exceeded analyst expectations (against historical average of 66%).  That is the good news.  The bad news is that aggregate S&P 500 is trending -5.65% lower - close to being classified as an earnings recession.

Another bright spot are new home sales, which increased by a healthy +10.8% in December.  Finally, the jobs #s continue their gradual improvement – jobless claims are down as is the unemployment rate.  Hiring data remains surprisingly resilient.

Only time will tell if last Wednesday’s “noon swoon” marks a capitulation low.  Most investors are stunned, frozen, and seem to have little appetite for risk.  For contrarians, these are perfect conditions to warrant a market rebound.  They live by the mantra “do not be fearful when others are fearful.”  Market bottoms are classically marked by high levels of skepticism.  Bears continue to become more emboldened and bulls are getting real edgy.  Opportunities tend to arise when investors are especially fearful. 

In addition, time will also tell us whether the plunge in oil prices was an early warning signal or if it was just a reaction to excess world supply.  For the bears, declining oil prices are the “canary in the coal mine” signaling slack economic demand.  Unfortunately, a lot of companies (and countries) rely on the higher oil and commodity prices (the 19-key commodities basket dropped an astounding 48% in the past year pushing more to the verge of bankruptcy).

In the end, it is all about expectations – whether or not the economic and company-by-company #s are better or worse than what the consensus was expecting and/or fearing.  One nice aspect to a selloff is that the expectations bar gets lowered making it easier to hurdle in future quarters.

To our way of thinking, we believe we are more likely to experience a garden variety slowdown - not a full-fledged recession (except in our manufacturing sector which is in the midst of a full blown recession). Remember, a lot can happen between now and year-end when the paint dries.  We believe it is time for patience not panic. Hoping we see a Koala rather than a grizzly bear.

We understand that this correction feels much scarier than recent selloffs.  Seems like there is a universal feeling that “things just don’t seem right”. It is ridiculous for one to speak with clarity on future economic scenarios.  That being said I put both ends of the spectrum (rapid growth or a deep recession) at a 25% probability.  The most likely outcome (put at 75%) is that we muddle along in a status quo mode or experience a garden variety slowdown.

We believe one needs to keep the recent volatility in perspective.  In the past we have experienced large and intra-year drawdowns yet  the market bounced back.  10% drawdowns happen, on average, once per year.  20% drawdowns occur in almost every business cycle.  5% to 10% draws happen three to four times per year. We wish volatility (especially the recent string) was unavoidable.  Unfortunately, it is part of the market.

When will this selloff end?  Hopefully when the "true data" overrides the "fear data". 

One last comment – do not be surprised if we have another flatish year in the markets – up or down +1-5%.  History shows these “resting years” are extremely common and do not warrant selling one’s holdings.

Group and Administrative Updates

Tax Docs: Please note that our clients will receive 2015 tax documents from both Fidelity and TD Ameritrade, due to the midyear custodian conversion.

Congrats Colin!: Pleased to announce that Colin Macleod has earned his securities licenses – congrats Colin, as these are very tough tests!

Website launch: we are also excited that we are moving towards launching a team website this Spring, which we hope clients will find valuable and informative.

As always, feel free to contact us any time to review your overall situation and particular needs.  We offer both portfolio management and financial planning (plus good old fashioned general advice) as part of our basket of client services.

If you would like to inform us of any updated contact information, please let us know as well.


Thank you,

Doug, Victoria, Randall, Ross, Patrick, and Colin