The Underlying Causes of Last Week’s (Exaggerated) Sell-Off
How bad can this sell-off get (Friday’s rally notwithstanding)?
Let me answer it this way. At this exact point three years ago the S&P 500 was coming off two months of (a) A United States Treasury Credit DOWNGRADE for the first time since Alexander Hamilton was Treasury Secretary; (b) The “up until midnight” threat of a full-blown government shutdown and budget impasse in Washington DC; (c) The realization that unemployment was still well north of 8% and GDP growth barely above 0%; and (d) Most importantly, the threat of a European contagion financial event as Greece and perhaps others threatened trillions of dollars of default. After a 19.5% drop the S&P 500 was sitting at 1,150. As I type this today in 2014, the S&P 500 sits at 1,863 (which represents a 7.5% drop from the high), and yet is 75% higher than it was three years ago in the midst of those conditions and panic. Please, dear clients and friends, pay attention to history here. I am just using the last significant drop as a lesson and not the last fifty drops which all teach the same thing. How bad can this sell-off get? I do not know. If someone tells you they do they are lying to you. I don’t believe this has a long way to go down but I don’t know and it would be irresponsible of me to try and pretend I do. What I do know is that the 2011-2014 example is one you should memorize. And, you can talk to me about it any time …
What is significant about May 2012?
The week of October 6-10 was a pretty ugly and volatile week in the stocks market. In fact, it was the worst since May of 2012. What was May 2012? I don’t even remember any issues in May 2012 and I remember EVERYTHING. That’s how much these things elongate through time. See my point? Vision and perspective are everything. Just over two years or so ago we had a week that was worse than last week was, and no one even remembers it just two years later.
What are other explanations for this market sell-off?
My belief is that it is more about Europe than is being understood. The numbers are atrocious. The often-celebrated Germany is itself joining the negative manufacturing/declining growth crowd. France’s credit rating was cut (it is still too high). So with hard landing data coming in regarding China’s slowdown, Japan’s continued struggles, and now European disappointment, I believe we’re getting a “global growth stinks” rally. Is this fundamentally sensible? Well, as Rick Golod at Invesco pointed out last week(1), Japan is in the same place they’ve been for 24 years, China’s slowdown is 3 or 4 years running now, and Europe couldn’t possibly be that big of a surprise (one would think). I believe all this likely means the sell-off may not be as long-lived as opportunistic buyers may want, but who knows. A deeper and longer sell-off is absolutely possible; I repeat: a deeper and longer sell-off is absolutely possible.
Well, this sell-off isn’t happening for no reason. What are the root causes?
A lot of theories are being thrown around. On one hand some suggest that a modestly higher dollar is hurting multi-national companies who export a lot and it is hurting oil companies who are now dealing with lower-priced oil. This short-term explanation is actually inaccurate, in my estimation, but let’s say it was the reason. The idea that a stronger U.S. Dollar is fundamentally BAD for dollar-based companies and a dollar-based economy in a dollar-based country is insane. A strong and stable greenback would be one of the best things our economy and stock market could hope for in the years ahead! The two strongest dollar rallies our lifetimes took place in the Reagan stock market of the mid-80’s and the Clinton stock market of the 90’s. Strong dollar, strong market. Dollar strength creates short term volatility until fundamentals re-prevail. The large multi-national companies know what to do when dollar strength hurts their export profits: They raise prices. Please don’t buy this “strong dollar is bad for the stock market” thesis. We should be praying for a stable price signal in our economy as stock market investors!
Is there more going on that may be disturbing markets (especially on last Wednesday’s volatile action)?
I don’t believe I could quantify or prove empirically my strongly held belief that one of the most significant market-shaking events of the week was the termination of Abbvie’s acquisition of Shire. You probably don’t know what Shire is (an Ireland-based biopharmaceutical company), but their stock had skyrocketed up in recent months with a large acquisition bid coming from Abbvie, the dividend-paying spin-off from Abbott Labs. The details aren’t important – and I doubt the broad market cares about these particular companies – but the REASONS for this deal being called off were, I believe, very concerning to the markets. For right or for wrong, the market feels that there is an overreaching Department of Justice and Treasury meddling in the markets …
But what about weaker oil prices killing the energy sector?
The research I am reading each and every day is abundantly clear. That has been a supply issue, and basically it was a Saudi-created supply issue a couple weeks back where they increased production surprisingly when most (including OPEC) expected them to cut it. I think they were trying to make a point that they still had the leverage and could take a price cut in their efforts to trump OPEC as far as production is concerned. Ultimately lower oil prices if they translate to lower gasoline prices do eventually serve as a tax cut in the economy, and I’m of the mindset that the consumer would benefit more from lower oil prices than we realize. As for the next move in crude oil, I will only say that with refinery margins where they now are I expect a demand recovery and as for supply I expect OPEC (and the Saudis) to cut production a great deal.
How do you think this market turmoil is affecting the dividend stock world you most care about?
I believe this sell-off has taken a lot of very good companies paying a very reliable and steady flow of income and made those stock responsible for the payment of income cheaper to buy. This is different than saying they have hit a bottom – it is merely stating the rather obvious fact that some very high quality companies have gotten lower in price, and that the cash flow they offer can be obtained for less (making the yield higher). I believe investors are more interested in growing dividends than ever, and that the current dividend payout ratio is substantially lower than its long-term average.
The untalked about wildcard for market strength?
S&P 500 companies are on track to spend $565 billion on stock buybacks this year (which increases earnings-per-share), and $349 billion on dividends (I sure wish those numbers were reversed). This represents about 94% of expected corporate profits for the index, vs. a historical average of 85% (2). What is missing in this equation is CAPEX – companies investing in capital expenditures that will grow the next evolution of their businesses. CAPEX has been too light for several years, and should it pick up, represents a potential wildcard for equity market ignition.
What does the market believe can be expected from the Fed when it comes to short term interest rates?
Clearly, the market doesn’t know what to believe. “Skittish” is the word. I have a long, long, long held (and published) view that the Fed will go longer than expected, not shorter. But attempts to make market projections and adjustments daily around anticipation of what the Fed will or will not do is futile. Don’t get me wrong – people are going to try, meaning there will be an additional cause for volatility as things progress, but there is not a directional or clear indicator of what the market believes the Fed will do because the skittishness is all over the map. My view? Volatility is your friend, and good quality will trump monetary confusion.
What are your present thoughts about Inflation?
I am upset with the crowd that predicted (or guaranteed) hyper-inflation and a collapse of the dollar due to quantitative easing when the money was never getting into the money supply, causing a segment of the investing public to not understand the dynamic of what was going on. The politics of inflation are louder than the economics of it, and that bothers me. With that said, I want SOME piece of my fixed income portfolio to be more prepared for the possibility of higher-than-expected inflation (which is nothing remotely close to hyper-inflation). I can prepare for that reasonably cheaply right now because no one is forecasting anything like it. When no one is scared of something, it makes me almost as concerned as when doomsdayers spread false information for the purpose of fear-mongering.
So tell us in a nutshell why MLP’s declined so much a week or two ago and tell us why MLP’s have already rebounded off of their bottom so much?
The second part is easy: MLP’s rebounded about 12-13% in the middle of this week (in my opinion) because they were deeply oversold without a fundamental basis for such a sell-off and I believe smart money came back in heavily. As to why they declined so much, I do believe that there is simply a different owner of MLP’s now than there used to be. A lot of “hot money” came into the space over the last year because the asset class did so well (“hot money” being my term for money that moves around a lot chasing hot dots). This kind of money is not known for making the smartest decisions in the world, and when the going got rough for energy in the last six weeks, indiscriminate selling kicked in. There is a point at which oil and/or gas prices could get so low that production would freeze up and the “tolls” that the pipelines collect for transporting oil and gas would be less voluminous. But this is what you need to know: We are MASSIVELY “under-built” for pipelines NOW; we need a gazillion MORE pipelines to handle just present capacity. At no point do pipelines take title to the commodity (oil or gas) running through them. There is and always will be price volatility, but the major fundamental reasons that we became significant investors in MLP’s some time ago is still in effect, and then some.
So are you saying that all MLP’s are totally fine?
I actually believe that each company needs to be evaluated on its own merits. Some companies are far more levered than others. Some are more diversified than others in terms of what parts of the country their pipelines spill. The characteristics of production in Arkansas right now are substantially different from the characteristics in Marcellus. Those with a heavy distillery operation and significant revenues in the Natural Gas Liquids (NGL) space are very different than the ones who only rely on crude oil. Read my White Paper on the subject for a general overview, but I WANT to see energy prices decline in the generation ahead, and I WANT to see us monetize the production, distribution, and infrastructure that will make this possible. It is no time for passive, uninformed exposure; MLP’s should be fundamentally selected and I cannot tell you how much conviction I have in the way we do that (ask me if you want more details).
Further thoughts on the recent sell-off and the weeks/months ahead?
I may have said this recently but I need to say it again: All the talk leading into my recent New York trip was “how do we prepare for what rising rates are going to do to dividend stocks, utilities, MLP’s, REIT’s, etc., etc.” … Rising rates have been the foregone conclusion for many (myself included) for so long, and the idea that rising rates would hurt many equity asset classes has been assumed for so long. The latter is deeply flawed, and obviously now we have seen the proof. Rates have CRATERED in the last few weeks. The 10-year bond yield started the year at 3% and dropped to 2.5% quite quickly. It settled in the 2.65-2.75% range and had been playing around there most of the year. Last week we dropped BELOW 2% momentarily and have lately been playing around between 2% and 2.2%. This is an insanely low rate environment, and yet wouldn’t that mean all the utilities, REIT’s, dividend stocks, MLP’s, etc. should have been richly rewarded? The bottom line is this, and I pray you will remember it for the year or two ahead: It is perfectly plausible that a sudden increase in interest rates (should it ever actually happen) would produce heavy volatility in the short term; but ultimately what is CAUSING the interest rate moves trumps all. Like so many things that have happened, and that will happen, I am working tirelessly and deciphering what will suffer short term price movements from various catalysts (i.e. interest rate movements, dollar strength, etc.) vs. what the longer term fundamental realities may be.
You have talked a lot about the dangers of short-termism when one has long term investment objectives, but I am 60 years old and retiring in two years. With two years to go, I can’t think about the long term any more … I now am a short term investor, right?
I disagree on that distinction. For a properly invested portfolio, the “term” is not when withdrawals START; it’s when they end. If a 60-year old plans to retire at age 62 they do not have a two-year timeline; they have a thirty-year timeline (or longer?). The need for the portfolio to SUSTAIN a, yes, LONG TERM flow of income trumps all. In that case the investor is not in a situation where they can’t afford short term price volatility; they’re in a situation where they can’t afford to go without it.
What you are trying to get out of your allocation to the bond market (fixed income investments) for clients?
I want to divide my objectives with bond investments to one of three categories:
(1) Core – meaning, regular old bonds, managed to reduce our correlation to the stock market, provide a lower risk profile, and generate some interest income and perhaps in some environments capital appreciation. Vanilla. Boring. I want this exposure in both a Global context and soon a very normalized U.S. context, knowing interest rates are inherently volatile.
(2) Rates – meaning, protection from rising interest rates. This is where my Floating Rate, Unconstrained, and Short Duration bond strategies come in. I have been very focused here for a long time
(3) Income – meaning, cash flow; investors who are taking the income these types of bonds kick off. I put High Yield and Preferreds in this space.
(You should note that Municipals would merely be a tax-free expression of #1 and in the case of Muni High Yield a tax-free expression of #3)
Are you worried about a wave of defaults in your bond exposures?
No, not right now, but I could become worried about such. Right now I am worried about one thing above all else: Liquidity. Dodd-Frank and Basel 3 have resulted in big banks slashing the inventory of high yield bonds they keep on their balance sheets. In times of heightened sellers there are quite simply less buyers there. This dynamic could affect Bank Loans as well. It is what we call a Technical concern, more than a Fundamental one. I spent a lot of time on my recent New York trip talking to our various bond managers about their management for liquidity risk. Some asset classes are going to face price volatility around liquidity squeezes and I am prepared to accept that. Defaults and poor fundamentals are what I need to avoid.
Can you see the United States stock market benefiting from global economic weakness?
I get the argument for this — that things get so bad elsewhere that it forces more and more capital into the U.S. pushing our risk asset prices up further. I am religiously committed to the immovable fact that MONEY HAS TO GO SOMEWHERE. However, let’s cautiously remember that in a globalized economy, if things got bad enough in Europe, China, Japan, etc., it would simply have to have an effect on U.S. growth and U.S. earnings as well. Money has to go somewhere, but it could always go from stocks to bonds, for example, not merely from “Euro stocks” to “U.S. stocks”. The key in my opinion is to focus on the areas that are more durable, more dependable, and less cyclical regardless of the global growth environment. I do, however, sympathize with the viewpoint that there is a relative attractiveness to U.S. stocks vs. many other country exposures.
QUOTE OF THE WEEK
“That men do not learn very much from the lessons of history is the most important of all the lessons that history has to teach.”
— Aldous Huxley