In our last piece on Aug. 5, before taking a two- week hiatus for some R&R, we pointed out that factory orders were flashing a warning sign, and the second quarter's increase in wages and salaries was the weakest on record and cause for serious concern, as was the phenomenal decline in prices over the past year for a wide spectrum of commodities -- pretty much Economics 101.
This week, that last point was driven home by mining giant BHP Billiton (BHP), which posted its worst results in 10 years amid the slide in commodity prices, with annual net profit of $1.91 billion, down 86.2% from the prior year's $13.83 billion, driven largely by a collapse in demand from China, its largest customer. As of yesterday's close, shares were down 26.5% year to date. Fellow mining giant Rio Tinto (RIO) also posted an 82% fall in first-half net profit earlier this month.
With the data we've watched roll in over the past two quarters, we weren't terribly surprised by the recent market turmoil -- nor, frankly, by the explosion in volatility. Rather, we were waiting for it. We've had significantly suppressed volatility for years, so naturally at some point it will turn into heightened volatility. In fact, the VIX rose an astounding 212% between Aug. 14 and Monday.
Most people are pointing to the correction in China, both the economy and stocks, as the cause of the recent rout, but we think that is much too simplistic. That may be the catalyst, but there are three other major realities at play:
1. The discrepancy between earnings and top-line revenue that has been going on for quite some time.
2. The ongoing weakness of the U.S. economy.
3. Slowing global growth.
Revenue growth for U.S. companies hasn't been terribly inspiring, yet earnings have been respectable thanks to cost cutting and financial manipulation. The cost cutting is a bit like going on a diet -- always a good idea to trim and tone where things have gotten flabby -- but it isn't something that can be done indefinitely; at some point you simply aren't getting enough nutrition, or in the case of a company that is not sufficiently investing for its future, and starts to harm longer-term health/growth.
Financial engineering with things like stock buybacks is the corporate equivalent of Spanx and a push-up bra -- looks good out in public, but back home the fundamentals really haven't changed.
As for the U.S. economy, we can keep this pretty simple. Wages, as we talked about earlier, aren't growing sufficiently. Baby boomers are retiring or in retirement. That means they spend less and, eventually, most of their assets will need to be sold, like homes, which will be an ongoing headwind to homebuilders. Millennials are burdened with more debt, thanks to insane secondary-education costs, than any generation before and continue to have weaker job prospects. Labor force participation rate continues to be at multidecade lows, which means we have a smaller percentage of the population to actually generate growth, and don't forget to check out USDebtClock.org to get an idea of just how heavy the current and future debt and entitlement burdens are; lots and lots of headwinds to growth internally with slowing external conditions as global growth weakens.
Yesterday, the Netherlands Bureau for Economic Policy Analysis reported that global trade shrunk in the first six months of 2015 at the fastest pace since global trade collapsed in 2009 following the financial crisis, down 1.5% in the first quarter and another 0.5% in 2Q. This is big, very big, yet very few are talking about it! Which is why we are.
About 45% of the world's GDP comes from commodity-producing nations, and we've already told you how grim the commodity story has been over the past year. While the U.S. may be the world's largest economy, China is second and it is the world's largest goods-producing economy. When it is slowing, that's telling you a lot about global demand.
So what's an investor to do? Make sure you have plenty of dry powder and get that shopping list honed. Despite the less-than-rosy economic picture, there will always be opportunities provided by major trends, such as the need for cybersecurity, which could mean something like the PureFunds ISE Cyber Security ETF (HACK).
We see rising demand for health care from all those aging populations around the world, from Japan to Europe to China to the U.S., which offers favorable long-term tailwinds for companies like Biogen (BIIB), Gilead Sciences (GILD), Amgen (AMGN) and Lab Corp. (LH), which have all come down significantly from their recent highs.
We think it's more likely than not that we have further to fall. Expect further market turbulence, and these stocks are still a bit rich for our blood, but pullbacks eventually mean much better buying opportunities.