This commentary was originally sent to Growth Seeker subscribers at 12:22 on Jan. 14.
Yesterday, the markets tried to be chipper thanks to what appeared on the surface to be positive trade data out of China (likely the data is, shall we say, a bit massaged) but lost all enthusiasm after eurozone industrial production numbers came in well below expectations and the U.S. Energy Information Administration announced the largest two-week oil inventory build in history. In the past four weeks U.S. fuel demand has declined 2.15%, while production rose 0.13%. That's not something we typically see in January, but then not much has been typical, lately.
The S&P 500 fell 2.5% yesterday, closing well below both its 50-day and 200-day moving averages. It's down 11.3% from its May 2015 highs and is looking to retest the August 2015 lows around 1860. Given what we are seeing, it is likely that it will break through, potentially after bumping around a bit, and will head to its next support level from February 2014, at 1820. The Russell 2000 closed down 3.3% yesterday; it has fallen 22% from its highs, has broken through the October 2014 support levels and looks to be on its way to its next support level, around its 2011 highs of 875.
Both WTI and Brent crude have dropped below $30 a barrel.
Half of the world's 20 largest developing country stock markets experienced falls of 20% or more in 2015. With the average stock in most of the major indices already down by over 20%, we're in a bear market, with a clear down trend for the first time in three years. So just what is driving this?
- The impact of falling oil and commodity prices. Over time, directional movements in oil and the S&P 500 tend to be fairly well correlated, but more importantly, when we've seen a divergence, the gap has tended to close in a relatively short period of time. The current period of underperformance for oil has not only been one of the largest in history, but is also by far the longest -- something had to give. There have been 10 material divergences in history, and all 10 have closed, leading us to believe that the likelihood that this one will not is very low. While falling oil prices help consumers of oil, energy groups have shelved around $400 billion of spending on new oil and gas projects since the crude price collapse, counteracting the boon to consumers from lower prices at the pump.
- It's tough to separate what is happening in the oil markets from the rising geopolitical tensions, particularly those between Saudi Arabia and Iran, which indicate that not only is a production cut by OPEC unlikely, but any near-term resolution to the Syrian civil war is also increasingly unlikely. This uncertainty and instability weighs on the markets, particularly the oil market.
- With no resolution to the strife in the Middle East and continued terrorist attacks, there is rising concern over how the eurozone is going to work through its immigration crisis, (and the internal rifts it is causing) on top of the deep structural problems and rising internal tensions caused by economic imbalances. While Germany has for years been finger-wagging at the southern nations for violating the eurozone sovereign debt guidelines, recently at least Italy has been pushing back, with Prime Minister Mario Renzi pointing out that Germany itself is in violation: "Germany has a trade surplus of 8%, and the rules say it should be 6% at most." Internal rancor reduces the market's confidence that much-needed reforms will be successfully negotiated and implemented. Add to it the reality that faith in the European Central Bank's ability to juice economic growth with more of the same relatively ineffective quantitative easing programs is rapidly deteriorating.
- Over in Japan, Abenomics hasn't delivered and the nation's debt keeps rising. The long game here is ugly.
- Global investors withdrew about $52 billion from emerging market equity and bond markets in the third quarter of 2015, which was the largest outflow on record, with net flows to emerging and frontier economies falling to zero, the lowest level since the financial crisis. We've seen the currencies of commodity export nations (Brazil, Indonesia, Russia, South Africa, etc.) fall to multi-year lows against both the U.S. dollar and multi-currency trade-weighted baskets. Add to this deteriorating economic performance in many emerging economies, with a good portion due to structural problems with declining productivity while global trade is slowing to multi-decade lows. Globalization is losing its dynamism. The year-over-year change in global exports is at lows seen only one other time since 1958.
- The most important of the emerging economies, China, has a highly unbalanced economy, with an exceptionally high savings rate coupled with a wastefully high investment rate and too much debt while the market's confidence in its leadership continues to fall. One way for China to address some of its problems would be to allow for capital outflows and depreciation of its currency, but that would be very destabilizing for the rest of the world and difficult to pull off at best, as Japan and the eurozone have already chosen that option. China's foreign currency reserves have already fallen 17% since June as it fought to keep its currency from depreciating further. We expect it to see the renminbi fall continue, while the PBOC attempts to slow the decline.
- Historically, the Fed has raised rates during market rallies and has never done so when the manufacturing PMI has been in contraction, and certainly not when it has been contracting for two consecutive months. The Fed's hawkish stance ¿ as the central bank is insisting that it will be acting based on the data coming in, while the data is showing ample signs of weakness -- is leaving the markets decidedly confused, which is never a good thing. The large flows of money out of emerging economies result in further dollar strength and are likely to make the Fed's decision look like a blunder; one more central bank losing street cred.
- The reality of the U.S. markets are historically high valuations with disappointing and declining revenues and earnings on top of a tumultuous and historically fractious election year that is likely to get a lot uglier before November.
- Looking back over the past 50 or so years, we've seen S&P 500 profit margins decline by 60 basis points or more seven times and only once, in 1985, did that not coincide with or predict a recession. We're in such a declining period today.
- Debt problems are going to reappear. In the past 30 years, we've never seen such a high percentage of companies in North America losing money at over 9%. Meanwhile, the default rate is at the lower end of historical norms, below 3%. Typically, U.S. corporate net debt and EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization -- aka operating cash flow) are pretty closely tied. Starting in 2013, EBITDA has flattened out and slowly started to trend down, while net debt has risen dramatically. We see record level of debt in emerging markets, with a $9.5 trillion dollar carry trade being unwound. Margin debt at U.S. banks is back to record levels. We have record levels of global debt...again. Global debt to GDP was 269% in 2007, today it is 286%. Something here has got to give.
- Falling oil prices are forcing the 56% of sovereign wealth funds from oil/energy production states to sell assets in order to plug the holes in the budgets. These funds typically invest in a lot of illiquid, long-term projects, so they are being forced to indiscriminately sell liquid securities where they can. In addition, all those high-profile hedge funds that have announced they are liquidating are also having to sell their assets. That makes for two large groups of forced sellers in an already falling market.
- Finally, time is a factor, since over the past 50 years there have been 19 bull market cycles and only one lasted over seven years, which makes our 6.5 year long run statistically rare.
What does this all mean for investors?
- Portfolio diversification becomes more important at this late stage in the cycle as there is less of a value cushion for being wrong and even great companies are getting caught up in the downtrend.
- In a world where there is very limited growth, investors will pay a premium for those stocks that are the growth stories. We are furiously putting together our shopping lists to grab up those growth stories are much more attractive prices when the dust settles.
- We need to see the bankruptcies we know are coming get going in the oil/energy sector before we will consider dipping our toes in. We are likely to see a series of dividend cuts from big oil here in the near term.
- We are avoiding anything to do with the commodity complex and emerging markets for now. At some point, there will be great opportunities, but this is not the time.
- Outside of the Growth Seeker portfolio, in the current climate, investors putting on new long positions should look for low volatility stocks such as consumer staples and utilities and avoid high beta stocks.
Over the next few weeks, we are likely get a few bounces in the market here and there, which we will likely use as opportunities to lock in some of our gains and increase our cash position in the Growth Seeker portfolio as we would feel much better putting capital to work when we have a reasonable level of conviction that the storm has passed.
As such, we will keep one eye on the market (the indicator of price) and the other eye on our investing themes looking for data points that reveal companies whose businesses will continue to perform regardless of what's happened in the stock market over the last month or will happen in the next month or next few months. If you were here with us, you would hear us asking each other questions like these:
- Has the drop in the stock market changed the outlook for cyber attacks and related threats in the longer term?
- Will consumers abandon the shift to online shopping even as more products become available to them?
- Despite the unseasonably warm temperatures in the eastern United States thanks to El Nino, has California's drought situation been eradicated?
- Has the shift toward streaming and other digital content consumption slowed because the stock market has lost close to $1 trillion in value, lessening the demand for content?
- Has the shifting demographics, with the largest bulk of the population in or near retirement, altered?
- As if by magic, did all those people with little to no retirement savings suddenly land on firm financial footing?
- Over the last few days, has the costly and deadly impact of obesity and prevalent condition of so many people being overweight been reversed?
- Have retailers, both brick & mortar as well as online, shifted to only taking cash and checks as payment for goods and services?
You get the point. Market valuations wax and wane at times, without regard to the underlying fundamentals.
It is easy to get caught up in the emotional response of the market moving lower, which usually is viewed as a bad thing, rather than an opportunity to buy shares at an even better price. When viewed through that lens, who doesn't love it when stocks go on sale... so long as the fundamentals and business drivers remain intact?
In markets like these, sometimes the potential gains to be made by waiting for a bounce are outweighed by the risks of a market that wants to keep going down, despite what, in some cases, are positive long-term company developments. When that happens, we find it far wiser, no matter how painful it may appear at the time, to just get out and live to fight another day, as we did earlier today with Mobileye (MBLY) and Taser International (TASR).
With the likelihood for the current market storm to continue, this tells us there is a high probability we'll be able to buy back a number of the growth positions and add new ones at the same or better prices, when the current market storm has cleared and things have settled down. While watching the markets tumble isn't fun for anyone, we at Growth Seeker are frankly excited by the prospect of being able to finally purchase shares at potentially seriously discounted levels relative to what's been possible in recent years.
Let's be prudent and patient together.