Market Washouts: Are We at a Bottom?
Was last week the week markets finally washed out, or is it just the beginning of more downside action to come? Are we at a bottom, near a bottom, and if so, where will that bottom be? Is the 10% correction we have been talking about in the S&P 500 for years finally about to happen? Beyond that, is the 20% bear market in our future? How low can oil go? How low can emerging markets go? All of these questions (and more) are dominating the headlines, and for some of you (hopefully not many), they are likely occupying mental space as well. We want to address what has been the worst week of the markets of the year last week (led by the worst day of the year, last Thursday). A full perspective on our portfolio positioning, macroeconomic perspective, and tactical approach to all of this will be the theme this week. Read on, take it in, and definitely read the concluding paragraph.
It was too brutal of a week to only read the summary… Read on, please.
What do you see as the cause of this week’s bloodbath?
Macro fears surrounding China, a deflationary negative feedback loop around commodity prices and oil (are they going down because of growth concerns or are there growth concerns because they are going down? Answer: Yes), and general concerns about Europe/global/China/Emerging markets growth. Two things stick out to us: The sell-off is not discerning, meaning virtually everything is selling off, so there is a broad and dramatic “risk off” move behind this which generally has meant over the years that it doesn’t much matter which of the multiple suspects are causing it – all risk assets get re-rated and revalued before normalcy can resume. Secondly, much of the growth disappointment or fear stems from the fact that expectations were not realistic. Is Europe looking to be in the doldrums? Of course it is. The Europe bulls of early 2015 are not talking a lot now as a violent level of QE there has not created any growth. We would not rule out the fact, either, that U.S. Q2 earnings were “okay”, when they really need to be “stellar” to sustain a better growth thesis.
So you believe it could get worse before it gets better?
Of course it could! We wouldn’t forecast one way or the other when it exactly turns or doesn’t turn. Our philosophy on such folly is well documented and well-known. What we do know is that this is not presently a mere “sell-off in energy” or sell-off in MLP’s or sell-off in oil – this is a broad-based sell-off in EVERYTHING. This means some things become more valuable, and we have a chance to benefit from this on the other side (overpriced assets should sell off; but under-priced assets that become more under-priced produce the opportunity we want to take advantage of.
What is your take on the U.S. dollar?
It was interesting that two weeks ago we saw the unexpected depreciation of the Chinese Yuan, a continued drop in the price of oil and gold and most other commodities, and poor economic growth reports out of Europe, AND YET saw the dollar slightly down on the week. The reality is that the dollar has enjoyed a substantial increase already against most world currencies (Euro, Yen, commodity countries, etc.), and its next move is not as clear as some may want you to think. Our big picture assessment is that we are in the early innings of a “race to the bottom” type of global currency war, and that the dollar will find footing and strength throughout this part of the process, but that at any time should the Fed desire a weaker dollar, they have all the tools and abilities they need to create one. From a policy standpoint, we are strong dollar advocates (meaning, what we WANT to be the case). From an investment standpoint, we are not in the camp that assumes a strong dollar will be the new norm. It is a crowded trade.
Do you expect the efforts of the Chinese to depreciate their currency will now stabilize for a while?
We do not. Short term, anything can happen and we wouldn’t offer a guess, but fundamentally China’s exports are in free fall (down 8.3% year-over-year), and that suggests further currency depreciation lies ahead. The markets are seemingly taking too much credence in what Chinese policymakers are saying instead of what the data is showing. We believe the Chinese yuan will have to depreciate further, but we also believe this likely sustains the commodity price pressure we have been experiencing and leaves a general uneasy feeling around risk assets.
If China were looking to sell some of their massive treasury holdings wouldn’t it have a bigger impact than anything the Fed might do?
Because the amount they would sell if they were to go this route is such a tiny percentage of their overall holdings, we wouldn’t expect it to have a material impact. They bought massive quantities in 2014, sold some $100 billion in the last few months (and yet rates DROPPED), and what they will do next is anyone’s guess. What would have a material impact on U.S. rates is if they stopped buying new issuance all together. Our Treasury new issuance, though, is way down, and there has been no shortage of buyers for any of it since the fed quit serving as main buyer with Quantitative Easing (QE).
Why do you keep any Emerging Markets exposure at all with all the downward pressure we see around China, around Russia, around commodity price distress, around the stronger U.S. dollar, etc.?
Because our emerging markets exposure and the specific strategy we use has shown over and over and over again that when the China/Russia/commodity/dollar/export/global cyclicality thesis gets hammered, our strategy sells off in the short term with everything, then experiences a very nice rebound around the realization of its fundamentals, its difference in approach, and its reduced correlation to all of those previously mentioned problems.
What are you looking for out of your bond portfolio right now?
Three things: A return that is lowly correlated with equities, some yield on the principal invested, and a decent expectation of return of principal during distressed times. We have a couple sectors in the fixed income universe that correlate higher to equities than we would like but have been attractive (and are attractive for other reasons) – good yield (income), and low risk of value deterioration from rising interest rates. Floating Rate has been in that boat for a long time, and yet does carry credit risk and economic risk we have to worry about.
You are always worried about rising rates hurting our bond portfolios. But won’t they also hurt our stock portfolios?
History says otherwise. Yes, we expect short term volatility around certain sectors when rates do finally rise, but we will not ignore the lesson of history in how equities have actually performed over last 25 years when interest rates rose (and admittedly they haven’t risen much over 25 years). The chart below shows a line of 10-year Treasury bond yields, with the green shading the periods where rates ROSE. Note the S&P 500 performance during those times. The reasons for rising rates matter more than the rates rising themselves.
Is all the stimulus in Japan helping to drive economic growth?
In what we can only assume would be causing John Maynard Keynes to rework his fundamental theories from the grave, Japan saw their second quarter GDP drop 1.6% quarter-over-quarter (with record levels of both fiscal and monetary stimulus). How significant is government spending in Japan to try and stimulate their 25-year no-growth economy? Try this chart on for size:
We are not sure what it will take to see Japanese growth take hold, but we expect more easing is coming, more deficit spending, more currency depreciation (perhaps even more so with China’s shot across the bow), and yet we do not believe these combined efforts will create the medicine so desperately needed: Growth. 1% GDP growth on the year will be considered a victory at this point: 1%.
What are your thoughts on the EPA report last week that seeks to require oil and gas companies to reduce methane emissions by 45% over the next decade?
It actually is quite mysterious. Cutting down on methane emissions is not just good for the environment, but it is in the best interests of the oil and gas companies who can capture the methane and capitalize on it as it makes for highly useful additional product. Oil production is up 100% over the last ten years and natural gas production is up 50%, and yet methane emissions are down 15% in that same period. In other words, this is a high profile regulation announcement that has little need or audience. It could create higher costs for some low cost producers (not well-timed), but for most it is much ado about nothing.
Shouldn’t this oil bloodbath (eight weeks in a row of price decline) be helping consumers with savings at the pump?
Here is the chart on what oil prices have done – the last third of the chart reflecting the last 12 months:
But notice this…
Gas prices are UP throughout this last turn down, not down. That disconnect means we don’t even get the chance to TEST the thesis, let alone disprove it. No, we do not believe that oil price declines in the context of fears of global growth slowdown, weak economics, and macro fears, lead people to save $25 at the gas station and then run out to Tiffany’s to spend $3,500. We think it is the strangest thesis we are routinely forced to encounter by the analyst community, and in this case not only is the conclusion wrong (weak gas prices means strong consumer), but the premise itself is wrong (that gas prices are weak).
Why does the macro economy matter? If we just care about company earnings do we need to care about the overall economy?
There is a certain wisdom in the question. Markets are always and forever a weighing machine on company earnings, and we are always and forever believers in the mechanism of free markets and self-interest to grow earnings through time. The data showing a disconnect between how a macro economy is doing and the markets in that same economy can often be severe and prolonged. With that said, our market has performed remarkably around earnings, and those earnings have come as profit margins have expanded. To see that continue we believe that revenues need to grow. The chart below shows how revenue growth was HUGE out of the 2008/2009 collapse, and that even though it has been positive the last several years too, the growth of sales/revenue has slowed. Our thesis has been that a better macroeconomic circumstance is necessary to drive revenue growth higher.
You always beat yourself up about things that don’t go the way you anticipated they might. What is something that has gone well in the portfolio in the midst of all this mayhem over the last year (energy markets, stock market, etc.)?
There are several things we may point to here but the one we will mention is the decision to exit small cap equity virtually entirely roughly a year ago. Those valuation-based calls sometimes leave you looking very dumb because you can be quite early (and that is a necessary part of being the value-investors that we are), but in this case the Russell 2000 is now completely flat over the last 18 months, having given back double digits since its peak, but the average losses on the smallest decile of market cap stocks are in excess of 45%. We could probably add that our ETF commodity exposure sold last October has declined 20% since that point as well. The reality is that we have a long track record of some calls being good, some calls being bad, and some calls seeming bad until they really, really seem good. That is a track record we think will play out into the future – fallibility, lessons learned, and yet a rigorous faithfulness to time-tested principles we believe are right for our clients.
The following appeared yesterday on our “ad hoc” blog where we frequently write mid-week on particular intra-week events related to the markets, the news, the fed, politics, etc. Sign up from our web site if you would like to receive these articles as they post:-
What do you have to say about the present market turmoil, the distrust in central banks we are seeing, and fears of global economic slowdown?
The markets are under significant distress with several 150 point drops taking place in the Dow this week. Commodities continue to be in free fall, especially crude oil which sits at $41 per barrel, a low not seen since the financial crisis. The Dow is now down about 3% on the year and the S&P is now slightly negative as well. More significant than where the total index lies, though, is this painful reality: 252 of the 500 stocks in the S&P are already down over 10% from their highs; and 120 of them are down over 20%. Yes, we are not yet at that technical “correction”, but functionally it is already happening.
The common question we face in times of turmoil is, “Where will the bottom be?” The answer is “we do not know”. The follow-up question is, “What is your guess?” The answer is, “We don’t believe in guesswork.” The response to the sigh that those two answers generate is for us to proactively say, “We are blessed with not needing to know exactly where the bottom will be, because we are generating an investment outcome that is agnostic about these types of things.” As a broad macro consideration which is applicable to how we allocate client capital, we have a point of view about global markets. Our points of consideration are:
- U.S. economic growth is positive but tepid, as it has been for several years, and barring any surprises is likely to remain as such. This means we do not believe impressive 3.5% growth is coming, and it means we do not believe negative growth – actual recessionary contractions are forthcoming. The tepid, lukewarm, chug-along economy we forecast is a by-product of what we believe to be uncertainty in monetary policy, low growth fiscal policy, excessive regulation, and missed opportunities in national energy policy
- Global economic growth is slower than U.S. economic growth – the growth we just called “tepid” in paragraph #1. We see Europe as a 0% growth zone, and China as a 5-6% growth zone where 7%+ has been the norm. Many emerging markets not run by Communists or incompetents offer better growth but those rates of growth are declining at present (particularly where such growth was dependent on commodity prices). Japan is a zero or even negative growth zone. In other words, we do not see a global recession, but we see very little international growth to excite us in the very short term. To the extent certain emerging economies offer better than average growth, and simply face short term headwinds around (a) Currency, and (b) Sentiment, we are extremely happy to continue investing here and accept short term volatility for the sake of the longer term result
- We do not believe the Fed will hike rates in September and we do not think it will matter much. We expect slow, coddling activity from the Fed which is boxed in by a rising dollar which is doing its tightening for it. Additionally, the Fed has committed itself to a path (in error, in our opinion) that says “we want to create 2% inflation”, and essentially the fact that this inflation has not (yet) surfaced indicates to us their far, far greater fear (deflation) will continue to win out. When pressed with the risks that inflation legitimately represent vs. the risks that deflation legitimately represent, central banks will always, always, always choose the side of deflation as the fear they feel most culpable to address.
- We are already in a balanced, somewhat “neutral” allocation positioning, and do not plan to change that yet. A recovery or sentiment reversal of note (to the upside) may cause us to become slightly more conservative, and a further drop in markets (5% more downside in the S&P 500) would likely cause us to increase risk assets, but overall we think our present allocations represent an appropriate positioning for these volatile times
- Oil prices are very important right now. Markets are pricing in all the negativity in the world, and crude oil may very well break $40 soon enough. We cannot emphasize enough how one-sided this trade is: All the money is on a strong dollar, weak oil viewpoint. We feel that when Mr. Market tilts the other way it will happen with FORCE and SPEED and VIOLENCE. We do not want to invest with the crowd. Our viewpoint is not one of “if the Saudis capitulate” but rather “when the Saudis capitulate”. We have no idea when that may be, but our viewpoint is that oil prices belong in the $60-75 range within the next year, and the investment implications of that are substantial.
We are watching oil prices. We are tactically maximizing the opportunity in MLP space. We are prepared for an increase in the present negative sentiment that is ruling the day. And we are convinced that this is a transitory period ruled more by sentiment than fundamentals. Investors are wise to focus on the only things that have ever mattered to a successful portfolio outcome: The avoidance of big mistakes.
QUOTE OF THE WEEK
“We should not look back unless it is to derive useful lessons from past errors, and for the purpose of profiting from dearly bought errors.”
– George Washington