Don’t Believe the Hype

This week I spent a lot of time speaking with clients that had fear that “the market” would continue to hand out irrecoverable losses.  This fear was motivating them to take pre-emptive action.  In a sort of Part 2 of what was discussed last week, I thought I would explore what may have driven that fear.  I think it came from two sources:  what they heard and what they saw.  Now you may say that, a legitimate cause of fear from previous circumstances drove their panic.  I will not disagree, but often as a disciplined investor you have to ignore triggers that remind you of past mistakes and experiences if you want to invest successfully.  Finding the opportunity in chaos is a lesson that will not only serve you well investing, but in life altogether.  What were some of the headlines stoking the fires of panic?  I am sure you heard or read some of them, so let’s cover a couple of them.

 

On the front page of this week’s edition of Barron’s was “Election follies rattle market“.  Here’s an excerpt of the article:

 

Sentient viewers must become numb to the political messages as they meld into the parade of pitches for local auto dealers and cures for maladies you’d rather not explain to the kids. But it seems that the financial markets may be becoming more sensitive to the presidential cage match.

With the global financial markets in free fall at midweek, politics seemed to be added to the list of usual suspects battering stocks and speculative-grade debt: corporate-earnings disappointments, China, and the ongoing collapse in oil and other commodities.

What strikes me as an interesting phrase is “politics seemed to be added to the list…”  For me, there are two things that drive market sentiment:  fear and greed.  As far as market fundamentals are concerned though, company earnings should be the overriding factor (see my article from last week for more on this).  However, if you just read this headline you may get the impression that the uncertainty around which candidate will lead the US in its economic turnaround has a very tangible effect on the performance of the market.  I doubt it does and long-term investors should focus on fundamentals.

They should ask a few questions:

  • Is the company making money (e.g. revenue)?
  • If they are, are they profitable (e.g. earnings)?
  • Are they growing both revenue and earnings consistently?
  • Do they have a competitive advantage in their sector or industry?

“Yes” answers to the preceding would indicate an investment that won’t likely be influenced by a presidential race.

Ok.  One more.  On Bloomberg, I found this headline:  “Are We Headed for Recession?”  First, let me say I cannot really argue with the content of this article because the author does a great job of exploring multiple perspectives of this question.  I will only refer to the sensationalism of the headline.  Because at this point, most articles with recession in the title will get read if they are written.  But let’s just briefly explore the notion of US GDP being negative for 2 consecutive quarters (recession defined).  What is GDP?  Gross domestic product consists of the value of all goods and services produced in an economy.  It is easiest to remember with this equation:  C + I + G + (X-M)

  • C = consumer spending
  • I = capital investment (or business spending)
  • G = government spending
  • X = exports of goods/services
  • M = imports of goods/services

Consumer spending makes up about two-thirds of the total number.  I believe consumer spending is the bedrock of GDP not just because it is such a large part, but it also drives business spending.  And as the article states, many positives exist in the economy to keep this number strong.  Maybe the most important is the relatively low cost of credit.  When it is cheaper to borrow, people spend more.  Spending leads to revenues and profits for businesses and when businesses have profits they spend.  Currently, there are not many signs to show that this is coming to an end anytime soon.  Higher interest rates may start to slow spending, but since they are so low now it may be a while before we see spending decrease because of them.  I think the other thing to keep in mind is that economic growth will not always correlate to market performance.  In a perfect world they probably should as this would make sense that profitable companies warrant higher valuations.  However, a down market should not make investors think we are headed towards recession.

I have recently been reading commentary by Howard Marks and he had a wonderful Benjamin Graham quote the other day:  “the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment.  I think the quote is pretty self-explanatory and demonstrates that focusing on the short-term volatility of the market is not consistent with investing based on market fundamentals.

No meaningful progress can be made towards investment goals by paying attention to headlines that instill fear, anxiety and panic.  Imagine trying to run a race while looking up into the sky waiting for rain or into the stands to see who is watching.  What would happen to you?  At best, you will likely lose the race, but at worse you may run into someone else’s lane causing injury to yourself and others.

Invest wisely!

 

 

 

 

 

Let’s Look at the Facts

  • Investor sentiment has driven the stock market to new lows in 2016.  However, investor sentiment is rarely reflective of market fundamentals (e.g. revenue and earnings growth).  I calculate an increase of nearly 64% for the S&P between the period of Jan 2011 to July 2015.  However over the same 4-year period corporate earnings have only increased by 25%.  Even worse, from the beginning of 2009 the S&P has returned 186% whereas corporate earnings have increased only 49%.  What gives?  I’d be the first to admit these two metrics don’t move in lock-step by the same amount, however if earnings growth drives returns, why has the market gone up by so much more than earnings growth?
  • Let’s explore what I would call an unusual divergence by looking at the market multiple.  In the last 10 years, the market was probably its cheapest right after the recession where the P/E ratio (measured by Case-Shiller) was 15x.  At the beginning of 2015, this same ratio stood at 26x.  This meant that since the Great Recession, investors were willing to pay 73% more to own shares of the S&P than they were back then.  Really?  Have corporate earnings warranted that great of a premium since then beginning of the recovery?  Possibly, but it doesn’t seem likely or logical once you consider our lackluster economic performance since that time.  It has been better than other developed economies (e.g. Europe, Japan), but by no means worthy of a multiple greater than 25x!  So if you consider all of that, possibly the question worth exploring for further evaluation is if the current hysteria around the latest market collapse should be getting this type of attention?  Could it be that the market has been overpriced all along and what we are currently experiencing is a normal market correction?  After all, weren’t we due?

 What really drives the economy? 

I suggest you view an incredible explanation of how the economy works by Ray Dalio because the following explanation deserves more time than I have here.  But think of what drives the economy–spending. Companies sell their goods and services and generate revenues. These revenues are use to expand through investment (also known as CAPEX) in fixed assets and human capital.  These investments are funded with cash or credit in order to result in greater production of goods and services.  Two-thirds of the US economy is driven by consumers who purchase these goods and services with cash or credit which then drive revenue which drives earnings–so on and so on.  By GDP standards, this cycle has been chugging along at a fairly pedestrian pace.  Corporate earnings are a part of GDP.  The stock market is separate from GDP and only really reflects investor sentiment about the machine I just described.

What could cause the market to go up so much more than corporate earnings?

Consider that monetary policy, until recently, has been “accommodative”.  This is proven by ultra low interest rates and even more dramatically, asset purchases.  These tools encourage something that could have harmful effects.  Low interest rates encourage spending because the cost of borrowing is cheap.  Asset purchasing puts cash in the hands of banks that can then use that cash to make loans to consumers.  The collateral affect is the “psychological effect” on investors to assume more risk relative to what they would normally assume.  An increase in the proportion of risky assets in an investor’s portfolio was encouraged because interest rate sensitive assets pay much lower returns comparatively. This “demand” for return found in risky assets pushes the overall level of asset prices up.  This is why I believe the S&P P/E ratio inflated so much during the time period of 2009 to 2015.

What happens when you remove the elixir?

I liken this to caffeine fast.  For all you coffee drinkers, you will appreciate the analogy.  I would like to suggest that the US economy is now being weaned off of the elixir of easy monetary policy. The reversal of monetary policy prior to an economy stable enough to repeat the cycle above on its own (without assistance) is potential disaster.  The US economy has to be slowly weaned off its dependence on easy credit and low interest rates to purchase goods and services.  The reality of the cost of future debt obligations in a higher rate environment starts to fuel unrest for the borrower and thus decreases consumer demand for those same goods and services.  This results in a pullback in capital spending by businesses looking to “soften” the blow of anticipated decreased revenues, and ultimately slows (or stops) job creation.  This creates a drag on GDP and if no growth happens for two consecutive quarters it is called a recession.

Let me be clear, in my opinion, I do not believe the US has yet reached this last stage.  However, I do believe there is plenty of evidence to show the US stock market was due for a correction to put market valuations more in line with reality.  Since, 1920 the market has averaged a P/E ratio in the mid-teens (call it 15x), so unless corporate earnings increase by a large measure or the market falls further stay tuned for continued volatility.  This is hardly a bad thing though as the universe of bargains is increasing with each market downturn.  Wise investors will do well to take a deep breath and circle the wagons.  The most prudent investors I’m working with currently have been making deposits for bargain purchases.  During the Depression, Sir John Templeton purchased 100 shares of all the NYSE listed stocks trading at less than $1 each to help catapult him to his fortunes.  Investors should consider that chaos creates opportunity.

Invest Wisely!

Suggested Reading to turn emotion into understanding:

Investment Ideas for 2016

Failing to plan is indeed planning to fail.  This is a quote we’ve all heard before and of course its implications are widely applicable.  In attempting to remove the cliché aspect from this post, I was faced with compromising a belief that I have that most success does come from proper planning.  The methodology [of planning] extends to virtually all aspects of life and can literally pay dividends for investors that survey the landscape for opportunities that will prove fruitful with a properly executed strategy.

What ideas will be best for 2016 and beyond?

Fallen Angels – Oil has fallen more than 50% over the last twelve months.  Companies that spent millions of dollars in infrastructure building (CAPEX) to dig wells, find oil and bring it to market are now hemorrhaging financially.  2015 was a year that saw relatively few bankruptcies and restructurings, however 2016-17 should be ripe with more of the same.  These fallen angels will present opportunities to investors that have a longer horizon to withstand the “bottom” in oil prices and ride it back to a point of stability.  Of particular note, have been oil refiners and pipeline companies that have performed although oil prices have declined.

Emerging Markets – Developing economies which are dependent on heavy commodity exporting were happy to see 2015 go.  My thoughts are that the underlying assets in this category may experience more pain in the interim, but are poised for big gains for longer holding periods.  Investors must remember that most markets are cyclical.  China’s growth over the last decade plus must be brought into equilibrium with other developed economies.  As growth slows in China, its trading partners will also experience slower growth until equilibrium of supply and demand are reached.  As this unfolds, emerging markets with strong political leadership and weak currencies stimulating domestic output will look to take advantage of the carnage from this most recent commodity decline and position themselves for future growth.

US Stocks – Bellwether mega cap companies with diversified operations are not currently cheap, but with continued volatility will look quite attractive.  As an example, technology companies like Apple have experienced selling pressure due to the slowdown in China specifically, but for a company with a 1/2 trillion dollar market cap and $41 billion of cash & cash equivalents on its balance sheet it has the luxury of waiting out this storm.  US corporations flush with cash have the option of using stock price pressures to increase their dividends or announce share buybacks.  Investors should remember that cash is king, and companies that produce a lot of it can represent good long term holds in any portfolio.

Municipal Bonds – If you have read any of my previous posts, you may have noticed my “soft spot” for municipal bonds.  This asset class is dear to me because of the relatively ease it presents for patient investors to accumulate safe total returns.  First, if you end up paying more than 25% in taxes in any given year, you should consider municipal bonds.  Most are exempt from federal income tax so you earn tax free income which on a tax equivalent basis gives you a boost.  Next, they usually offer better yields than US treasury bonds and similarly rated corporate bonds.  So for the diligent investor that dedicates a portion of their portfolio to this asset class, tax free investment returns can be used to accelerate net cash flow in the portfolio over a longer time horizon.

These are just a few ideas investors should be considering as investments for their portfolios.  However, remember that the planning process–not just the ideas—is a crucial step in any investment strategy.

Invest Wisely!