Monday, August 24, 2015

“Do not try to buy at the bottom and sell at the top. It cannot be done - except by liars.” -The great speculator, Bernard Baruch

Anytime you have a stock market like we had last week, you start to question yourself. The S&P unexpectedly lost 5.7% and is now down 3.1% for the year through Friday, August 21st. Most of the damage was done on only two trading days, Thursday and Friday, when the markets fell roughly 5%. At the current time, the Dow Jones Industrial Average now sits in correction territory having lost 10% from its all-time high. While the S&P and the NASDAQ are just shy of a 10% correction, it seems a lot worse since the losses all occurred in one calendar week.

It is very important when the market sells off like this to evaluate why the market was so volatile on the downside, and maybe what course of action you should do in the future from the upside. There is no question we are closely evaluating the daily volatility and reevaluating what steps we should make. However, this particular selloff seems to defy most any type of logic, and certainly the economic numbers do not support it. I thought I would give you a mid-month update and just see whether you agree if the numbers are realistic or not.

It is important to understand that a 10% correction in the market is not particularly unusual. As we often quote in these postings, you can expect a 10% movement in the market virtually at any time. It has been unusually calm for the last four years and we really have not had a movement that large. We came very close in October 2014, when the S&P bounced up against the 10%, but did not close below that level. Even though we are not at that level yet, for anyone to assume that a movement such as this is rare or unusual is just misinformed. Markets move sometimes for no particular reason. However, it looks like the reason for this movement centers principally on the Chinese economy, and certainly not based upon U.S. economics.

Stock markets tend to fall into major down cycles when the economy is moving towards a recession. There certainly is no evidence that any recession in the United States is anywhere close. The second read on the GDP for the second quarter was at 2.3%. It is generally believed that the final read on the GDP will increase the GDP in the second quarter to above 3%. The current projection for the third quarter GDP also is greater than 3%. Clearly, there is no reason to assume the U.S. economy is anywhere close to falling into a recession.

Contrary to the tragedy in the European markets last week, the European economy continues to improve. Manufacturing in Europe is better and improving. While Japan is certainly not gangbusters, it is also certainly not currently in a recession. While the slowdown in China is troublesome, their last read on the GDP was 7% and there are few who believe it will fall into a recession anytime soon. It must be remembered that the Chinese government has strong control over their economy, and they have shown a desire and willingness to support the economy and hold a higher level of growth. I would fully expect that they will continue to do so this time if a true slowdown occurs.

While I guess what is particularly baffling to me is that when China devalued their currency two weeks ago its sole purpose was to stimulate exports, which is very good for the U.S. economy. Basically that means the goods we buy from China will be cheaper in the future. We actually export very little into China. It is believed that exports to China amount to less than 1% of the GDP for the United States, UK, France, Italy and Spain; Germany exports 2.6% to China; and 2.7% for Japan. None of these numbers are extraordinarily high, and certainly the Chinese economy is not going to zero. Assuming that there is a decline of 25% in exports to China, the effect on the GDP in the United States would only be one quarter of 1% - almost insignificant.

Interestingly, economic numbers of the United States were particularly robust with residential existing house sales expanding at one of the fastest rate ever to its pre-2007 level. New housing starts are up over 10% for the year-over-year numbers and nonresidential spending is up a robust 15%. The unemployment rate is 5.3% and the number of unemployed has fallen 15% year-over-year. Yes, if you are confused by the very upbeat economic news in the United States and the stock market performance that lost over 5% in one week, you would not be the only one.

To even further confuse the issue, large U.S. bank stocks fell close to 10% last week in trading. That is very difficult to reconcile given the strong economic numbers - and clearly they have zero exposure to China. Yes, you could understand the decline in oil related stocks, but now with Royal Dutch Shell and BP yielding 7% on their dividends, you would have to think even that is overblown. So we have to sit back and decide whether there is economic support for continuing to invest in the stock market or moving aside.

At the current time, the Standard & Poor’s index of 500 stocks is selling at a reasonable 16.7 times earnings for 2015. The current dividend yield is 2.2%, which is higher than the 10-year Treasury bond. Therefore stocks, even in this broad-based index, would appear to be a much better investment than bonds.

The numbers are even more pronounced in the Dow Jones Industrial Average, which sells at a 15.9 times earnings and has a dividend yield of 2.6%. The Euro Stoxx 50, which is the 50 largest companies within the Euro countries, is selling at an extraordinarily low 13.9 times earnings with a 3.8% dividend yield. Even the extraordinarily beat up Shanghai composite is valued at a modest 14.4 times earnings with a 1.8% dividend yield.

There was a lot of commentary this week about the decline in Apple stock. Interestingly, this company fell 6% on Friday alone. It was argued that investors were concerned about Apple selling iPhones into China. While it is true that China is its second-largest market after the United States, what was not pointed out was that Apple buys virtually every iPhone they sell from China, which would be cheaper with their currency devalued. Just on a financial ratio basis alone, Apple sells at 9 times earnings if you reduce its value by its $150 billion in cash. There has hardly been a company that grows at a 30% annual basis net of its cash sell for such a low multiple.

I have closely reviewed all the data and information from the weekend press. At the current time, I see no change warranted in our long-term investment philosophy. Market movements such as this are not rare or terribly unusual. However, we will continue to evaluate the situation and see if by chance we have misread the economic data or we clearly do not comprehend its importance, although I see nothing at the current time to warrant any type of prolonged selloff.

It seems to me that a good deal of this selloff has to do with financial engineering and not economics. Since there is clearly not an economic event, it must be something other than the economy. In 2007 and 2008, there was clearly an economic event. People seem to forget that the GDP in 2008 a negative 6.5%. We are anticipating a positive 3% GDP growth at the current time, so clearly that is not the cause.

Sometimes you wake up with a conspiracy theory that all the market momentum people crowded into the same trade. Oil is a good example of that phenomenon. Currently, oil is selling at less than $40 a barrel, even though that is less than the cost to extract it from the ground. This is in spite of massive cutbacks on the number of rigs drilling oil and the budgets to exploit that oil. Nothing at this point indicates that the price of oil should be in the $30’s per barrel, yet that is where it is trading at today. You may rest assured that the oil companies would not agree that $30 is a fair price.

I guess we will not know whether this is financial engineering until the market turns around. If, as I suspect, everyone is short to market you will see a massive short-cover rally soon, and the market will go up as quickly as it went down. Both of these are financial and not economic, and the move up would be equally as meaningless as the move down has been.

While the markets may not jump back this week, the markets will definitely do so at some point soon since it clearly cannot be a long-term down market when economic statistics continue to be extraordinarily robust and positive as they are now.

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

Best Regards,
Joe Rollins