Friday, October 24, 2014


From the Desk of Joe Rollins

Transcribed Thursday, October 16, 2014

The stock market has sold off for the last three weeks for a lot of different reasons, which I would like to try to explain from my point of view. Anytime there is a large movement in the market, I attempt to analyze the underlying issues to determine if the issues are real issues or issues just perceived by the public. There is absolutely no question that when the market goes down, everyone feels pain. The question for us, as investors, is whether we need to change what we are doing or whether we should maintain our positions and wade through the downturn.

First, this may be hard to absorb, but the market movement has actually not been as bad as the public perceives. The S&P is down only 8.5% from its all-time record high. You have to have a movement of 10% or greater to realize a correction; we have not reached that level yet. I realize that we could reach that level, but as of Thursday morning, the market is holding strong at that percentage.

There is no question in my mind that the major driver of the downturn is the fear of the Ebola virus and it’s potential to spread. While watching the news at 4:30 a.m. yesterday morning, it was announced that the most recent Ebola patient was allowed to fly on a commercial airline with the permission of the CDC. Almost immediately after that announcement was made, the Dow futures dropped over 100 points. The panel of commentators on the financial show all expressed fears that an Ebola epidemic would cause the public to limit their actions insofar as going out or traveling. In other words, they are afraid that people will stop going to movie theaters, stop going shopping (which in turn they forecast as negative news for Christmas sales), and they would certainly stop flying. But when you consider that there are only two people in the United States, of which we are currently aware, to have contracted the virus from a population of over 300 million, that seems to be a fairly extreme position in my opinion.

The other major driver is that the price of crude oil has dropped from over $100 per barrel down to about $80 per barrel. The argument here is that a lack of demand for oil signifies an economy in a downturn. If there is no demand for oil, either the consumers cannot afford it or businesses are suffering so much that there is no demand for fuel for trucks and other industries. While certainly that might be the case in Europe, there is no evidence that is the case in the United States. In addition, the strengthening dollar, as I will discuss below, has an effect on the price of imported oil, making it more expensive. Consequently, oil production in the United States is more attractive, since there is not the high cost of transportation from the Middle East. Frankly, our energy prices are not a negative to me; in fact, it all sounds fairly positive.

We have been talking for years about the very important economic effect of higher production of energy in the United States. It has been somewhat surprising that that this additional production of crude oil did not lead to lower prices for consumers years ago. In fact, we expected to see lower prices much sooner than now.

So is this reduction in crude oil prices due to oversupply and economics of demand/supply, or is it in fact due to the upcoming recession either in this country or in Europe? Certainly there is no evidence of the downturn in the economy in the United States, so you have to think that it is mainly due to supply and reductions in demand.

It appears to me that the fair price for oil is somewhere around $90 per barrel and it must be realized that the price of oil can only go down so much. When the price of oil reaches a level of the cost of production, the wells will just be capped. When you use fracking to extract oil from shale, your cost of production is much greater than under normal extraction techniques. Therefore, it does not seem that the price of oil could fall much lower than it is today.

The positive spin on the low price of oil is that this is a huge benefit for the consumers. If consumers have lower gasoline prices and lower commodity prices, that is good for everyone. Virtually every industry uses energy in some form or another, and lower prices are good for everyone.

The other major concern is the strengthening dollar. Once again, this should not be much of a surprise to anyone. The 10-year treasury bond in Germany is at 0.8%, less than 1%. It should not surprise anyone that people from Europe are investing their dollars in the United States, where the interest rates are much higher, even at the miniscule rate of 2% annually for a 10-year treasury bond.

It is true that when the dollar strengthens, U.S. companies that sell products to international consumers are less competitive while selling outside of the United States. Many of the S&P 500 companies receive a significant portion of their revenue base in a foreign currency. While it is true that these prices will definitely go up and make them less competitive in other countries, it also positively impacts all assets held in the United States based on U.S. dollar terms. It also brings back money from overseas to the United States, which also increases the value of the dollar. Of little notice is that many companies hedge their currencies. Much of the manufacturing takes place outside of the United States, and then products are shipped to other countries outside of the United States. In return, this (in dollar terms) should not greatly affect profits of corporations.

The other major concern that is affecting the market is the deterioration in the European economies. For many years, the European Union has been fighting over whether they should stimulate their economy with government support, or whether they should allow economies to sink or swim based upon their own momentum. The cost of government in Europe is well over 50%, and therefore it is hard to affect pricing when the government controls so much of the economy.

In France, Italy, and the smaller European countries, they are begging the government to stimulate the economy, while Germany refuses to participate. Of all the European countries, Germany has the tightest grip on their economy and is scared to death of inflation. European economies are basically functioning at a breakeven GDP, there is certainly no evidence that those countries will spiral down into a major recession. While European economies are weak in comparison to that of the United States, it is hard to imagine that this would have a long-term effect on the U.S. economy.

I have written many times in these blogs that you can expect a 10% down movement in equity markets, either up or down, at any time. Over the last 50 years, there have been 30 times when the markets have moved at least 10%. With that being said, it is not an unusual circumstance. That does not mean that we do not take this movement seriously. We watch it every day and study the fundamentals to determine whether a change needs to be made in our basic investment philosophy. For the period ended September 30, 2014, the S&P was up 19.7% for the one year period. Therefore, even with a 10% move down, the S&P would still be up almost double digits over the last year.

In analyzing the fundamentals, it is important to make sure that something has not changed that we need to address. I constantly review economic reports and earnings to determine whether some adjustments need to be analyzed. It is just unusual to see a movement this large without some sort of economic reason. Certainly, if you are in the camp that you believe Ebola is going to develop into a pandemic throughout the United States, then of course, there is your economic reason. The effect of lower oil prices, the stronger dollar, and the mild economic weakness in Europe certainly would not have the same negative economic ramifications.

What is interesting is that all the economic fundamentals are clearly intact. I have been watching corporate earnings very closely over the last couple weeks, and all of them appear to not only be strong, but above expectations. Interest rates have fallen to 2% on a 10-year treasury bond, which in return helps all aspects of the economy. Now consumers are realizing lower mortgage payments, and every facet of credit is cheaper due to the lower rates. The economy recently appears to be on track for 3% GDP growth, which by no definition would indicate any type of weakness. Therefore, the three components that we analyze to determine whether stock prices are reasonable are all intact: earnings are great, interest rates are low, and the economy is stable and growing. Therefore, fundamentally, there is no change from our opinion that stock prices should move higher.

An explanation is needed to understand the fundamentals of momentum traders. The so-called “fast money” moves strictly on momentum and not on fundamentals. They move a market in the direction of what the trend is, either up or down. When you see the large volume that occurred in the markets on Wednesday, October 15, 2014, you realize the fast money, or momentum traders, were involved. Due to the huge volume that occurred, it could only be them trading in such enormous share volumes.

This is not to say that these momentum traders would not have an effect on the overall market at the end of the day. On the other hand, it does prove that it does not reflect fundamentals. Therefore, it is probably not relevant for future stock prices.

The conundrum for investors (such as us) is whether we should make a large fundamental change in our positions to accommodate a short-term scare or momentum traders changing the direction of the overall market. The fear, of course, is that being uninvested, the momentum traders could shift gears and the market could go up as much as it is down over the same relevant time period.

When momentum traders sell the market, they usually do so with a technique known as shorting the indexes. Along with any other investors, the traders only have so much capital to work with, and therefore are limited as to how much they can move the market. It is inevitable that at some point they would have to cover the shorts, meaning they would buy the indexes to cover the shorts. This unwinding of the shorting technique creates upward pressure on the market, which is positive. Since the moves by the momentum traders are designed to make short term profits, none of these transactions will happen in the long-term.

In summary, after a review of all the fundamentals and the underlying economy, we have made an election to hold our position and watch it for a few more days. That does not mean we will not change our opinion tomorrow, but today (Thursday, October 16th) it appears that the fundamentals are intact. Interest rates tend to be low and the threat of Ebola is so small that it is virtually meaningless. Of course we would be more than happy to notify you if our thoughts change.

If you are still feeling uncomfortable regarding the movements in the equity market, even after reading this, then please give us a call and we would be happy to discuss it with you and update your portfolio to reflect any conservative path you would prefer to take. In the meantime, as I write this post, the market has rallied back to breakeven, which is a positive compared to the last several weeks.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins