Posts filed under ‘Themes – Trends’
At the trough of the recent correction, which was underscored by a brief but sharp -1,100 point drop in the Dow Jones Industrial Average, the Dow had temporarily corrected by -16.2% from its peak in May, earlier this year. Whether we retest or break below the 15,370 level again is debatable, but with the Dow almost reaching “bear market” (-20%) territory, it begs the question of whether the U.S. has caught a recessionary flu from the ill international markets’ colds?
Certainly, several factors have investors concerned about a potential recession, including the following: slowing growth and financial market instability in China; contraction of -0.4% in Japan’s Q2 GDP growth; and turmoil in emerging markets like Russia and Brazil. With stock prices down more than double digits, it appears investors factored in a significant chance of a recession occurring. Although the Tech Bubble of 2000 and generational Great Recession of 2008-2009 were no ordinary recessions, your more garden variety recessions like the 1980 and 1990 recessions resulted in peak to trough declines in the Dow Jones Industrial Average of -20.5% and -22.5%, respectively.
In other words, with the Dow recently down -16.2% in three months, investors were awfully close to factoring in a full blown U.S. recession. Should this be the case? In answering this question, one must certainly understand the stock market is a predicting or discounting mechanism. However, if we pull out our economic thermometers, right now there are no definitive indicators sending us to the recessionary doctor’s office. Here are a number of the indicators to review.
Yield Curve Indicator
For starters, let’s take a look at the yield curve. Traditionally, in a normally expanding economy, we would normally expect inflationary expectations and a term premium for holding longer maturity bonds to equate to a positively shaped yield curve (e.g., shorter term 2-Year Treasuries with interest rates lower than 30-Year Treasuries). Interestingly, historically an inverted yield curve (shorter term interest rates are higher than longer term rates) has been an excellent leading indicator and warning signal for unhealthy stock market conditions forthcoming.
As you can see in the charts below, before the two preceding recessions, in the years 2000 and 2007, we experienced an inverted yield curve that served as a tremendous warning signal in advance of significant downdrafts in stock prices. If you fast forward to today, the slope of the yield curve is fairly steeply sloped – nowhere close to inverted. When the yield curve flattens meaningfully, I will become much more cautious.
The Oil Price Indicator
There is substantial interest and focus on the recessionary conditions in the energy sector, and more specifically the high yield (junk bond) issuers that could suffer. It is true that high yield energy credit spreads have widened, but typically this sector’s pain has been the economy’s gain, and vice versa. The chart below shows that the gray shaded recessionary time periods have classically been preceded by spikes upward in oil prices. As you know, we currently are experiencing the opposite trend. Over the last 12 months, WTI oil prices have been chopped by more than half to $45 per barrel. This is effectively a massive tax for consumers, which should help support the economy.
Other Macro Statistics
Toward the top of any recession-causing, fear factor list right now is China. Slowing economic growth and an unstable Shanghai stock market has investors nervously biting their nails. Although China is the 2nd largest global economy behind the U.S., China still only accounts for about 15% of overall global economic activity, and U.S. exports to the region only account for about 0.7% of our GDP, according to veteran Value investor Bill Nygren. If on top of the China concern you layer a fairly strong U.S. labor market, an improving housing market (albeit slowly), and a recently revised higher GDP statistics, you could probably agree the economic dashboard is not signaling bright red flashing lights.
There is never a shortage of concerns to worry about, including most recently the slowing growth and stock market turbulence in China. While volatility may be implying sickness and international markets may be reaching for the Kleenex box, the yield curve, oil prices, and other macroeconomic indicators are signaling the outlook for U.S. stock remains relatively healthy.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
“In the middle of every difficulty lies an opportunity.” ~Albert Einstein
It was a painful week for bullish investors in the stock market as evidenced by the -1,018 point drop in the Dow Jones Industrial Average, equivalent to approximately a -6% decline. The S&P 500 index did not fare any better, and the loss for the tech-heavy NASDAQ index was down closer to -7% for the week.
The media is attributing much of the short-term weakness to a triple Chinese whammy of factors: 1) Currency devaluation of the Yuan; 2) Weaker Chinese manufacturing data registering in at the lowest level in over six years; and 3) A collapsing Chinese stock market.
As the second largest economy on the planet, developments in China should not be ignored, however these dynamics should be put in the proper context. With respect to China’s currency devaluation, Scott Grannis at Calafia Beach Pundit puts the foreign exchange developments in proper perspective. If you consider the devaluation of the Yuan by -4%, this change only reverses a small fraction of the Chinese currency appreciation that has taken place over the last decade (see chart below). Grannis rightfully points out the -25% collapse in the value of the euro relative to the U.S. dollar is much more significant than the minor move in the Yuan. Moreover, although the move by the People’s Bank of China (PBOC) makes America’s exports to China less cost competitive, this move by Chinese bankers is designed to address exactly what investors are majorly concern about – slowing growth in Asia.
Although the weak Chinese manufacturing data is disconcerting, this data is nothing new – the same manufacturing data has been very choppy over the last four years. On the last China issue relating to its stock market, investors should be reminded that despite the massive decline in the Shanghai Composite, the index is still up by more than +50% versus a year ago (see chart below)
Fear the Falling Knife?
Given the fresh carnage in the U.S. and foreign markets, is now the time for investors to attempt to catch a falling knife? Catching knives for a living can be a dangerous profession, and many investors – professionals and amateurs alike – have lost financial fingers and blood by attempting to prematurely purchase plummeting securities. Rather than trying to time the market, which is nearly impossible to do consistently, it’s more important to have a disciplined, unemotional investing framework in place.
Hall of Fame investor Peter Lynch sarcastically highlighted the difficulty in timing the market, “I can’t recall ever once having seen the name of a market timer on Forbes‘ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”
Readers of my blog, Investing Caffeine understand I am a bottom-up investor when it comes to individual security selection with the help of our proprietary S.H.G.R. model, but those individual investment decisions are made within Sidoxia’s broader, four-pronged macro framework (see also Don’t be a Fool, Follow the Stool). As a reminder, driving our global views are the following four factors: a) Profits; b) Interest rates; c) Sentiment; and Valuations. Currently, two of the four indicators are flashing green (Interest rates and Sentiment), and the other two are neutral (Profits and Valuations).
- Profits (Neutral): Profits are at record highs, but a strong dollar, weak energy sector, and sluggish growth internationally have slowed the trajectory of earnings.
- Valuation (Neutral): At an overall P/E of about 18x’s profits for the S&P 500, current valuations are near historical averages. For CAPE investors who have missed the tripling in stock prices, you can reference prior discussions (see CAPE Smells Like BS). I could make the case that stocks are very attractive with a 6% earnings yield (inverse P/E ratio) compared to a 2% 10—Year Treasury bond, but I’ll take off my rose-colored glasses.
- Interest Rates (Positive): Rates are at unambiguously low levels, which, all else equal, is a clear-cut positive for all cash generating asset classes, including stocks. With an unmistakably “dovish” Federal Reserve in place, whether the 0.25% interest rate hike comes next month, or next year will have little bearing on the current shape of the yield curve. Chairman Yellen has made it clear the trajectory of rate increases will be very gradual, so it will take a major shift in economic trends to move this factor into Neutral or Negative territory.
- Sentiment (Positive): Following the investment herd can be very dangerous for your financial health. We saw that in spades during the late-1990s in the technology industry and also during the mid-2000s in the housing sector. As Warren Buffett says, it is best to “buy fear and sell greed” – last week we saw a lot of fear.
In addition to the immense outflows out of stock funds (see also Great Rotation) , panic was clearly evident in the market last week as shown by the Volatility Index (VIX), a.k.a., the “Fear Gauge.” In general, volatility over the last five years has been on a declining trend, however every 6-12 months, some macro concern inevitably rears its ugly head and volatility spikes higher. With the VIX exploding higher by an amazing +118% last week to a level of 28.03, it is proof positive how quickly sentiment can change in the stock market.
Not much in the investing world works exactly like science, but buying stocks during previous fear spikes, when the VIX level exceeds 20, has been a very lucrative strategy. As you can see from the chart below, there have been numerous occasions over the last five years when the over-20 level has been breached, which has coincided with temporary stock declines in the range of -8% to -22%. However, had you held onto stocks, without adding to them, you would have earned an +84% return (excluding dividends) in the S&P 500 index. Absent the 2011 period, when investors were simultaneously digesting a debt downgrade, deep European recession, and domestic political fireworks surrounding a debt ceiling, these periods of elevated volatility have been relatively short-lived.
Whether this will be the absolute best time to buy stocks is tough to say. Stocks are falling like knives, and in many instances prices have been sliced by more than -10%, -20%, or -30%. It’s time to compile your shopping list, because valuations in many areas are becoming more compelling and eventually gravity will run its full course. That’s when your strategy needs to shift from avoiding the falling knives to finding the bouncing tennis balls…excuse me while I grab my tennis racket.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including emerging market/Chinese ETFs, but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Commodity prices, including oil, are “crashing” according to the pundits and fears are building that this is a precursor to another stock market collapse. Are we on an irreversible path of repeating the bloodbath carnage of the 2008-2009 Great Recession?
Fortunately for investors, markets move in cycles and the fundamental laws of supply and demand hold true in both bull and bear markets, across all financial markets. Whether we are talking about stocks, bonds, copper, gold, currencies, or pork bellies, markets persistently move like a pendulum through periods of excess supply and demand. In other words, weakness in prices create stronger demand and less supply, whereas strength in prices creates weakening demand and more supply.
Since energy makes the world go round and the vast majority of drivers are accustomed to filling up their gas tanks, the average consumer is familiar with recent negative price developments in the crude oil markets. Eighteenth-century economist Adam Smith would be proud that the laws of supply and demand have help up just as well today as they did when he wrote Wealth of Nations in 1776.
It is true that overall stagnation in global economic demand in recent years, along with the strengthening of the U.S. dollar (because of better relative growth), has contributed to downward trending oil prices. It is also true that supply factors, such as Saudi Arabia’s insistence to maintain production and the boom in U.S. oil production due to new fracking technologies (see chart below), have arguably had a larger negative impact on the more than -50% deterioration in oil prices. Fears of additional Iranian oil supply hitting the global oil markets as a result of the Iranian nuclear deal have also added to the downward pressure on prices.
What is bad for oil prices and the oil producers is good news for the rest of the economy. Transportation is the lubricant of the global economy, and therefore lower oil prices will act as a stimulant for large swaths of the global marketplace. Here in the U.S., consumer savings from lower energy prices have largely been used to pay down debt (deleverage), but eventually, the longer oil prices remain depressed, incremental savings should filter into our economy through increased consumer spending.
But prices are likely not going to stay low forever because producers are responding drastically to the price declines. All one needs to do is look at the radical falloff in the oil producer rig count (see chart below). As you can see, the rig count has fallen by more than -50% within a six month period, meaning at some point, the decline in global production will eventually provide a floor to prices and ultimately provide a tailwind.
If we broaden our perspective beyond just oil, and look at the broader commodity complex, we can see that the recent decline in commodity prices has been painful, but nowhere near the Armageddon scenario experienced during 2008-2009 (see chart below – gray areas = recessions).
Although this conversation has focused on commodities, the same supply-demand principles apply to the stock market as well. Stock market prices as measured by the S&P 500 index have remained near record levels, but as I have written in the past, the records cannot be attributed to the lackluster demand from retail investors (see ICI fund flow data).
Although U.S. stock fundamentals remain relatively strong (e.g., earnings, interest rates, valuations, psychology), much of the strength can be explained by the constrained supply of stocks. How has stock supply been constrained? Some key factors include the trillions in dollars of supply soaked up by record M&A activity (mergers and acquisition) and share buybacks.
In addition to the declining stock supply from M&A and share buybacks, there has been limited supply of new IPO issues (initial public offerings) coming to market, as evidenced by the declines in IPO dollar and unit volumes in the first half of 2015, as compared to last year. More specifically, first half IPO dollar volmes were down -41% to $19.2 billion and the number of 2015 IPOs has declined -27% to 116 from 160 for the same time period.
Price cycles vary dramatically in price and duration across all financial markets, including stocks, bonds, oil, interest rates, currencies, gold, and pork bellies, among others. Not even the smartest individual or most powerful computer on the planet can consistently time the short-term shifts in financial markets, but using the powerful economic laws of supply and demand can help you profitably make adjustments to your investment portfolio(s).
See Also – The Lesson of a Lifetime (Investing Caffeine)
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (July 1, 2015). Subscribe on the right side of the page for the complete text.
Watching Greece fall apart over the last five years has been like watching a slow motion train wreck. To many, this small country of 11 million people that borders the Mediterranean, Aegean, and Ionian Seas is known more for its Greek culture (including Zeus, Parthenon, Olympics) and its food (calamari, gyros, and Ouzo) than it is known for financial bailouts. Nevertheless, ever since the financial crisis of 2008-2009, observers have repeatedly predicted the debt-laden country will default on its €323 billion mountain of obligations (see chart below – approximately $350 billion in dollars) and subsequently exit the 19-member eurozone currency membership (a.k.a.,”Grexit”).
Now that Greece has failed to repay less than 1% of its full €240 billion bailout obligation – the €1.5 billion payment due to the IMF (International Monetary Fund) by June 30th – the default train is coming closer to falling off the tracks. Whether Greece will ultimately crash itself out of the eurozone will be dependent on the outcome of this week’s surprise Greek referendum (general vote by citizens) mandated by Prime Minister Alexis Tsipras, the leader of Greece’s left-wing Syriza party. By voting “No” on further bailout austerity measures recommended by the European Union Commission, including deeper tax increases and pension cuts, the Greek people would effectively be choosing a Grexit over additional painful tax increases and deeper pension cuts.
And who can blame the Greeks for being a little grouchy? You might not be too happy either if you witnessed your country experience an economic decline of greater than 25% (see Greece Gross Domestic Product chart below); 25% overall unemployment (and 50% youth unemployment); government worker cuts of greater than 20%; and stifling taxes to boot. Sure, Greeks should still shoulder much of the blame. After all, they are the ones who piled on $100s of billions of debt and overspent on the pensions of a bloated public workforce, and ran unsustainable fiscal deficits.
For any casual history observers, the current Greek financial crisis should come as no surprise, especially if you consider the Greeks have a longstanding habit of not paying their bills. Over the last two centuries or so, since the country became independent, the Greek government has spent about 90 years in default (almost 50% of the time). More specifically, the Greeks defaulted on external sovereign debt in 1826, 1843, 1860, 1894 and 1932.
The difference between now and past years can be explained by Greece now being a part of the European Union and the euro currency, which means the Greeks actually do have to pay their bills…if they want to remain a part of the common currency. During past defaults, the Greek central bank could easily devalue their currency (the drachma) and fire up the printing presses to create as much currency as needed to pay down debts. If the planned Greek referendum this week results in a “No” vote, there is a much higher probability that the Greek government will need to dust off those drachma printing presses.
Protest, riots, defaults, changing governments, and new currencies make for entertaining television viewing, but these events probably don’t hold much significance as it relates to the long-term outlook of your investments and the financial markets. In the case of Greece, I believe it is safe to say the economic bark is much worse than the bite. For starters, Greece accounts for less than 2% of Europe’s overall economy, and about 0.3% of the global economy.
Since I live out on the West Coast, the chart below caught my fancy because it also places the current Greek situation into proper proportion. Take the city of L.A. (Los Angeles – red bar) for example…this single city alone accounts for almost 3x the size of Greece’s total economy (far right on chart – blue bar).
Give Me My Money!
It hasn’t been a fun year for Greek banks. Depositors, who have been flocking to the banks, withdrew about $45 billion in cash from their accounts, over an eight month period (see chart below). Before the Greek government decided to mandatorily close the banks in recent days and implement capital controls limiting depositors to daily ATM withdrawals of only $66.
But once again, let’s put the situation into context. From an overall Greek banking sector perspective, the four largest Greek Banks (Bank of Greece, Piraeus Bank, Eurobank Ergasias, Alpha Bank) account for about 90% of all Greek banking assets. Combined, these banks currently have an equity market value of about $14 billion and assets on the balance sheets of $400 billion – these numbers are obviously in flux. For comparison purposes, Bank of America Corp. (BAC) alone has an equity market value of $179 billion and $2.1 trillion in assets.
Anxiety Remains High
Skeptical bears will occasionally acknowledge the miniscule-ness of Greece, but then quickly follow up with their conspiracy theory or domino effect hypothesis. In other words, the skeptics believe a contagion effect of an impending Grexit will ripple through larger economies, such as Italy and Spain, with crippling force. Thus far, as you can see from the chart below, Greece’s financial problems have been largely contained within its borders. In fact, weaker economies such as Spain, Portugal, Ireland, and Italy have fared much better – and actually improving in most cases. In recent days, 10-year yields on government bonds in countries like Portugal, Italy, and Spain have hovered around or below 3% – nowhere near the peak levels seen during 2008 – 2011.
Other doubting Thomases compare Greece to situations like Lehman Brothers, Long Term Capital Management, and the subprime housing market, in which underestimated situations snowballed into much worse outcomes. As I explain in one of my newer articles (see Missing the Forest for the Trees), the difference between Greece and the other financial collapses is the duration of this situation. The Greek circumstance has been a 5-year long train wreck that has allowed everyone to prepare for a possible Grexit. Rather than agonize over every news headline, if you are committed to the practice of worrying, I would recommend you focus on an alternative disaster that cannot be found on the front page of all newspapers.
There is bound to be more volatility ahead for investors, and the referendum vote later this week could provide that volatility spark. Regardless of the news story du jour, any of your concerns should be occupied by other more important worrisome issues. So, unless you are an investor in a Greek bank or a gyro restaurant in Athens, you should focus your efforts on long-term financial goals and objectives. Ignoring the noisy news flow and constructing a diversified investment portfolio across a range of asset classes will allow you to avoid the harmful consequences of the slow motion, multi-year Greek train wreck.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) and BAC, but at the time of publishing, SCM had no direct position in Bank of Greece, Piraeus Bank, Eurobank Ergasias, Alpha Bank or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on ICContact page.
Just days ago, billionaire investor and corporate activist Carl Icahn called the stock market “extremely overheated,” especially as it relates to high yield bonds. He communicated these comments over Twitter after saying markets are “sailing in dangerous unchartered waters.” Given recent Greek developments regarding its inability to strike a debt repayment deal with eurozone leaders, Mr. Icahn might get exactly the volatility he expected when he made those comments. There’s no question a Greek default could definitely cause a short-term contagion effect, but there will be much larger fish to fry than domestic equity markets (I will have much more to say on the Greek topic in my monthly newsletter).
While it’s difficult to argue with Carl Icahn’s long-term investment track record, currently there is little objective data (unemployment, yield curve, corporate profits, GDP, etc.) signaling an imminent recession or economic collapse. Whether you are an optimist or pessimist, there is no doubt we have come a long ways since the lows of 2009 – see Global Stock Market chart below:
The rapid price appreciation has been undeniable, but Mr. Icahn and other equity bears may be missing the forest for the trees. There has been a disproportional increase in the value of bond assets versus equity assets. More specifically, as can be seen from the chart below, the value of global financial assets increased an estimated +21.5% to $294 trillion from 2007 to 2014. Of the $52 trillion increase in global financial assets, 92% of the increase ($48 trillion) was derived from expanding debt obligations – not stocks. I’ve said it many times before, but if you are worried about the pricking of an equity bubble, make sure to buy some heavy-duty industrial ear plugs for eventual pricking of the bond bubble.
Former Treasury Secretary and Harvard President Larry Summers recently commented in an interview that a potential “Grexit” could have unforeseen consequences just like the situations leading to the collapse of Lehman Brothers, Long Term Capital Management, and the subprime market. At the time, those particular circumstances were underestimated and characterized as being “contained”. Today, we are hearing the opposite regarding Greece.
In a post financial crisis world, every financial molehill is made into a crisis mountain as it spreads through social media and appears on every TV show, blog, newspaper, and magazine article. In a post financial crisis world characterized with ultra-low central bank interest rate policies, a combination of excessive conservatism from individual investors and opportunistic corporate actions (e.g., share buybacks and M&A), has led to a lopsided increase in debt issuance. Case in point is the bloated debt balances held by the Greek government. There will inevitably be pain associated with a Greek default and potential exit from the euro, but due to its size (<2% of European GDP), Greece should be treated more like a pimple than a body rash.
If you want to reach your financial goals, you need to prudently manage your risk through a broad asset allocation and realize that experiencing turbulence is part of the investing game. The impending Greece default will not be the first financial crisis, nor the last one. Extreme growth in debt should be more of a concern than a tiny, financially irresponsible country missing a debt payment. But rather than panicking, it is wiser to maintain a long-term investment strategy coupled with a globally diversified portfolio across asset classes, which will allow you to not miss the forest for the trees.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on ICContact page.