Market Panic: The Unforgettable Week
This has not been a week that me or my team are going to forget any time soon. For those of you who chose to pay attention to the market last week (we hope that is a small number), you may not forget it any time soon either. To avoid any kind of unfair melodrama, the last four months of 2008 contained no less than six weeks which ALL were more dramatic than this one, and frankly 2011 contained a couple that had last week beat too (in terms of point movements, volatility, headlines, etc.). But I can say that I will never forget last week because (a) I was cursed/blessed with a memory that most people would not believe; and (b) It was a stunning culmination of how hard we have worked for so, so long. We preach investor discipline and non-emotional behavior as the single key ingredient to long term investor success, and we could not be more proud of how our clients scored in this regard. We advocate as a matter of near zealotry the principles of value investing, cash flow generation as a defining report card, and alternatives as a risk mitigator – and we believe that all three of these things were validated last week, and speaking more opportunistically, we believe they all became positioned for great things in the period that lies ahead. I would humbly ask you to read the whole commentary this week as there really is a plethora of information that I worked hard to make simple and succinct, and yet tells a complete story which ought to be told in this present market context. Let’s get into it …
Markets experienced wild volatility throughout the week, beginning with thousand point swings on last Monday, record setting down days and up days, and ultimately demonstrating tremendous turbulence as major market indices entered their first official mathematical correction (10% drop from peak to trough) since 2011. Panic levels as evidenced by cash levels and the VIX exceeded points that in the past have been huge indicators of market rallies to come. Nearly half the time a market correction takes place the bottom is set within a week or so, which doesn’t tell us if that is the case here. A question we are struggling with: Was the panic high enough here to really indicate the worst being behind us? Dividend-growth strategies like ours are useful in a time like this, not just for the math of the dividend (though don’t ignore that), but for the more stable business model of the underlying company. Our job is not to know what the markets will do next – it is to tell you that NO ONE knows what the market will do next. When MLP yield spreads have reached these levels, 100% of past occasions have seen a 12-month total return in excess of 20%.
Oil prices are low behind supply manipulation, not waning demand – that is a game-changer in how one ought to think about it. The ability of a central bank to disrupt markets (whether markets hate the disruption or love it) should never be discounted; one could bathe in a pool of bearishness if they want to, but they can get their face blown off if they get caught on the wrong side of a central bank action (and by central bank, we don’t just mean the Fed, but now China’s as well). The Fed’s zero-interest-rate-policy surely didn’t create hyper-inflation as many predicted, but it did create much excessive risk-taking and stretching that will require a tough unwinding. Intra-year downside market volatility is the rule, not the exception. An average intra-year decline of 14% over the last 35 years has not stopped 77% of those years from being positive. Our theses: Position your portfolio around your very specific tolerance for volatility, and with that said, overweight alternatives, treasure dividend growth, and use selective Emerging Markets for long term growth.
So what exactly went on last week????
Markets closed last week as the worst week in nearly four years, which is (a) Bad because it was the worst week in four years, and (b) Hard to remember that we had a week worse four years ago! The market dropped over 1,000 points last week, and we entered last week with Monday morning futures pointing to a big drop (roughly 400 points). But then the opening bell rang, and boom, we were down 600, 700, 800, 900, 1,000, and close to 1,100 points – in minutes. We then rallied back nearly 1,000 points, and then sold off again. We teeter-tottered back and forth between 300 down and 800 down and everything in between before closing down 588 points (bringing the Dow to below 16,000). The S&P 500 officially got its long-awaited 10% correction. And one of the worst days in Wall Street history was over, Tuesday morning we woke up to futures pointing to a 450 or 500 point increase in the Dow. China had sold off sharply (again) overnight, but their central bank announced a cut of their one year lending rate and an intention to provide long term liquidity to support their economy. Tuesday ended up seeing a 400 point increase turn into a 200 point decrease as markets sold off everything in the final 20 minutes of trading. Wednesday morning saw a 300 point increase at the open, and markets actually added to the gains throughout the day. By the close the Dow was up 619 points, the third biggest point increase in history. Thursday morning saw the rally continue with a triple digit increase at the open, and markets responded favorably to GDP revisions from Q2. We shall see what Friday’s market action creates.
What are the best indicators of how markets generally perform coming out of a panic?
We have real structural problems in our markets. There are real headwinds in the global economy. There is a strategy that needs to go into how one positions a portfolio right now. But with all that said, history is clear: When cash levels top out, the subsequent move is huge for equities. Note the recent four peaks in money market levels. The three prior to the latest resulted in significant double digit moves in equities. Why does this happen? Because emotional investors ALWAYS do the wrong thing, at the wrong time – always.
Take a look at the VIX in this chart. It is an options measurement of fear, essentially. Look at the spikes after these various ugly market events. 100% of the time – you read that right – spikes in this VIX/fear level were followed by double digit moves in the market.
What do you know statistically about market corrections?
We believe from the core of our being that what happened in one case does not guarantee a given outcome in another case, but 43% of the time the market has dropped 10% it has bottomed within one week of that happening. Charts of recoveries look like symmetrical V-shapes, meaning that the quicker the correction took to happen, the quicker the recovery tends to happen, and the longer a correction took to happen, the longer a recovery may take. We cannot and will not get sucked into these sort of trivial metrics – what will drive our decision-making is pure fundamentals. Do we believe the events of last week could mean even worst times ahead? Of course, that could happen. But bear markets come out of valuation excesses, and they come out of recessions. Recessions come from the end of a virtuous business cycle, and that means 100% of the time an inverted yield curve (the 10-year yielding more than the 30-year). We know a significant global recession could pull the U.S. into a recession, but we do not believe that is in the cards at this time. Positioning needs to be a by-product of a client profile – how a client’s objectives and risk appetite pair. We couple those realities with a point of view, and then make decisions. We do not respond to headlines, because when we do, client outcomes suffer.
Does the market bounce back in the middle of last week cause you to believe THIS market correction’s bottom has already come and gone?
Not necessarily, and here is why. (Believe me, I know you want me to say “yes”, but hear me out). The capitulation activity last Monday had all the feel of a normal panic out (meaning, a bottom coming). Weak hands shake out in a correction, a bottom gets set, and markets re-gain direction around normal fundamentals. In this case, though, there really was an extremely high sense of level-headedness in this correction. I think corrections end when levelheadedness gets thrown out the window. Perhaps there was an adequate amount of pain and panic this time, or perhaps enough investors have now learned from the last four corrections how these things generally play out and have been willing to see this thing through like good long term investors. But my read of markets is such that further downside volatility would not be any kind of surprise.
What do you believe about YOUR investment approach during these types of markets? You’ve surely seen these types of things before.
Indeed we have. And we have studied many more of these types of things than even the ones that have existed in the last 20 years. What our approach focuses on is significant and secure income generation. We do not want our client’s investment objectives to be altered during market turbulence, and we do want to deny the reality of market turbulence. Individual position review and a proactive analysis of portfolio allocations are a continual part of our process, but we manage on a customized basis for each individual client and we do so around a massive bias towards income-generative investments. These growing dividends offset much market turbulence, but they also indicate more dependable and stable business models and therefore investment outcomes. We are now in a period where from a BUYER’S PERSPECTIVE, many rock solid dividend-paying, dividend-growing names have fallen into even higher yielding positions. We end up with the anxiety that having too many good deals to buy becomes challenging. Our investment approach insists on prioritizing cash flow generation through thick and thin. Times like these end up validating that approach in a big way.
You say frequently that you do not know what exactly the stock market will do next, and I can appreciate your candor, but isn’t it your job to know? Fair question. But no, it isn’t. It is, however, my job to tell you that no one knows what exactly the market will do next, and I include in that statement us at The Bahnsen Group, and then also everyone else in the world.
With all that is happening in the markets, don’t lose sight of MLP updates!!
How could we? The overall thesis we hold to is more intact than ever. When yield spreads exceed 500 basis points over Treasuries in the MLP space, total returns for MLP’s have been positive 100% of the time. Does history repeat itself here? We shall see. But we would recommend you re-read that last sentence a few times. 12-month returns for MLP’s after yield spreads have reached these levels vary between 21% and 37%. We don’t know if or when commodity prices (oil and natural gas liquids) will accelerate the reversion to the mean which will amplify MLP returns, but we do know that poor sentiment notwithstanding, the revenue model is alive and well, the macro thesis is alive and well, and we believe rewards are coming.
Help us understand better why you don’t necessarily believe oil and natural gas prices have to come higher for MLP prices to recover?
Tell me if this chart explains that thesis or not … Prices dropped across the board in late 2008, but a year later pipeline prices began a multi-year recovery led by volumes and distributions, even as gas prices stayed low. The recent drop in MLP pipeline prices coincides with the drop in oil prices last year. The investment thesis in MLP’s is based on continued income, continued desire for that income, and continued growth in that income. It is an infrastructure thesis, and it is not one we remotely want to abandon, though we want to continually remind investors it requires patience and a memory of the underlying objective.
Is the collapse in oil prices of the last eleven months now looking to be a by-product of collapsing demand as opposed to excessive supply?
There are few things I want to get wrong less than this, but the answer is simply “no”. This has been a supply-driven drop from day one, and we have combed the globe for signs that it is demand driven. Our belief is resolute: this is Saudi-driven supply manipulation with a geopolitical objective more than economic one. We have no ability to time a recovery, but we are highly skeptical that this is yet remotely demand-oriented.
How would you see some of the immediate steps playing out in much of this market turmoil?
There has been a consistent pattern for a long time of central bank intervention becoming a mitigating factor in market corrections. This used to be a reference to the federal reserve but lately it has covered much of the global landscape as well, from Draghi and the European Central Bank to Abe and Japan as well. And this brings me to the immediate situation and why I’d be deathly afraid to take on an overly short term bearish posture right now … Few central banks on the planet have as many tools at their disposal as China. Debates exist as to what they will do, what they should do, and how what happens will impact America. But to deny that some sort of monetary policy action may be forthcoming which causes a huge “melt up” in markets is to have a poor view of history. I’m happy to couple this consideration with thoughts on the longer term ramifications, but my point is that China’s central bank has so much dry powder, we encourage investors to be careful making any large one-directional bets.
So you don’t see our own central bank getting much involved?
We have been saying for over a year that they will raise rates later than people think, and in recent months we’ve been highly and vocally skeptical that they would hike in September. We believe they should, but we believe there is no chance they will. This is actually one of the huge catastrophic risks the Fed has taken of economic conditions were to worsen: They have left themselves with no wiggle room.
Do you believe we could end up seeing a QE4?
Dear Lord. If we do, it would cause me much angst to think that some clients may be happy about such! No, we don’t think that will happen, but do we think the Fed would even blink before doing so if they thought economic conditions warranted such coaxing? No, we do not.
So are critics of the Fed’s zero interest rate policy (ZIRP) now being vindicated?
It depends. There have been two types of critics of the Fed’s 0% interest rate policy over the years, as neatly summarized by the amazing Louis-Vincent Gave: (1) Those who claimed ZIRP would create hyper-inflation, and that the safest place to go would be gold and commodities; (2) Those who criticized ZIRP as a distorter of risk and encourager of mal-investment, but not as an inflation bogeyman in the midst of global deflationary fears. And then of course the third camp was wildly excited about Fed policy … Within the two critical camps, we think it’s safe to say that the second category has been spot on, but obviously not the first. No serious conversation contains talk of hyper-inflation these days, and yet all honest conversations include realistic assessment of the impact zero percent interest rates have had on decision making.
Would you say the volatility we have seen last week is unprecedented?
We want to say that, because it would paint a picture that though this month has been uncomfortable, the normal path ahead in the lifetime of an investor is usually smooth and easy. History tells a different tale, and you can decide if this is encouraging or discouraging. Over the last 35 years the AVERAGE “intra-year” decline has been 14.2% – average. That is MORE than we have seen this month! We had an intra-year decline every single year, and yet in 27 out of 35 years (77% of the time), the calendar year final return was POSITIVE. This chart here is one of the most powerful realities I can share. “But we want a smoother ride”. No problem! I hear you! And we can take some my points off of the expected return by taking steps to decrease expected volatility … But you have to know the facts and what the trade-offs are. Intra-year volatility is scary, and one’s asset allocation absolutely has to factor in their tolerance for market volatility, even much more sustained downside volatility than we have seen as of late.
positions going forward. Our emerging markets position is hugely opportunistic at these levels for growth oriented investors but very much requires patience as macro conditions unfold. We want greater exposure to alternatives in the months and years to come to tilt some of the beta risk towards manager risk. And we want to positively marinate in the long term investment outcomes that happen from consistent dividend growth, especially when it is systematically reinvested.
QUOTE(S) OF THE WEEK:
“Good judgment comes from experience, and a lot of that comes from bad judgment.”
– Will Rogers
” If you see stocks that you think look cheap and you don’t buy them, you don’t just look like an idiot, you are an idiot.”
– Jeremy Grantham
“If you can keep your head when all about you are losing theirs … Yours is the Earth and everything that’s in it.”
– Rudyard Kipling
I was tempted to make this week’s commentary much longer. I read several books worth of material last week on China, on the 1997-98 emerging markets crisis, on crude oil inventories and supply/demand dynamics, and of course on overall market health and earnings impact. The truisms I most wanted to share with a broader audience this week made the commentary. Next week depending on the noise in the markets we’ll plan to unpack more of what is happening around the world, and what it means to us not just for this week or next week, but for the next several years. I hate the idea of any clients of mine, for whom I care about deeply, experiencing distress or anxiety, and we remain on call to discuss such anxiety with any of you who would like to. We plan to continue conducting abundant research, avoid making imprudent decisions, and execute faithfully on plans that serve our clients well. To that end, we work.