The famed investor and “father of value investing”, Benjamin Graham, explained that in the short-run the market is like a voting machine, tallying up which stocks are popular and which ones are not. In the long-run, however, the market is like a weighing machine; assessing the substance and value of companies based on fundamentals. The “voting machine” which is most concerned with the crowd’s opinion appears to have switched from a “glass half full” to a “glass half empty” sentiment with some extreme viewpoints to boot in the third quarter. The fundamental picture is not all that different than a few months ago when markets were at all-time highs, yet the third quarter is decidedly negative in all risk asset classes.
From the beginning of the year and with increasing focus, the market appears concerned about three main issues: China’s economy slowing, low oil prices, and the Federal Reserve raising interest rates. Related to these three issues was concern over an increase in the strength of the U.S. dollar and the fact that the U.S. market had seen all-time highs and traded slightly above historical valuations.
It is important to note that these issues are not new in the sense that they showed up in the third quarter with notably new information, but rather seems to be simply a shift in sentiment as some of these issues became seen as more permanent and not as short-term as once thought. This change in mood and risk-taking behavior is not something we view as insignificant, as market prices are very much a reflection of what people are willing to pay, but is it less concerning than a strong deterioration in growth and earnings. As fundamentally-based investors who look at the factors that affect the “weighing machine” long-term, this dramatic price movement can be frustrating. Sir Isaac Newton once lamented (after losing a large sum of money in a stock) that,
“I can predict the movement of heavenly bodies, but not the madness of crowds.”
China’s economy, the second largest economy in world has been slowing for nearly five years. There are a few things to consider regarding this issue. First is the law of large numbers, the larger an economy gets, the harder it is to continue to grow at a rapid pace; financial gravity historically has existed in stock prices and economic growth rates. Perspective is in order as the U.S struggles to grow at above 2%, and China is slowing from 7% to potentially 6.5%-5.5%. China has had an incredible expansion due to investment in real estate development and infrastructure spending, which eventually comes to an end when done in excess. This overbuilding and debt overhang seems to be a cause of some of their slowdown as well. Lastly, China’s president, Xi Jinping, has touted a multi-year process of structural reform which would shift to a more balanced consumption-based economy that is not dominated by heavy manufacturing and exports. This policy change should also slow the economy to a more modest growth rate; a “new normal”. While China’s economy has a large impact on the worldwide economy (particularly in Asia), we should not only look at the headlines of the papers, nor should we translate its slowing as a direct or dramatic impact to the U.S. economy, as the link does not seem that strong. Taking all of this into consideration, we feel today that China’s slowdown is to be expected and at this point may not be as bad as many are currently voting.
One of the biggest concerns by professional investors is that the Chinese Government is not transparent with their data and some fear that things are actually different than what is reported. Chinese leaders are learning lessons the hard way that markets and foreign capital don’t like surprises and uncertainty. The surprise currency devaluation they announced in August 10th, while understandable, was not taken well by investors.
As mentioned, China’s economy does have ripple effects throughout the world. One such ripple is in the oil markets. As we have written about recently, low oil prices have been weighing on the markets. Lower growth in China and around the world we feel results in investors projecting that oil supply will continue to outpace demand and keep oil prices low for a very long time. The near-term reaction apparently is that investors flee energy and oil-related stocks and worry of dividend cuts, defaults, and bankruptcies. You can see the pessimism priced into oil stocks as well as other energy-related stocks. One such related investment is mid-stream MLPs (Master Limited Partnerships) whose businesses shouldn’t be sensitive to oil prices, but only production levels and volumes, which haven’t really declined. However, mid-stream MLPs have been hit with the “baby and the bathwater” phenomenon. Likewise, many high yield bonds across the board have experienced heavy selling. Energy makes up around 15% of the high yield bond market, however, the point is, many if not all high yield bonds have sold-off, even though many bonds aren’t affected by the price of oil and U.S economic growth is still positive. We view this as a sign of panic by some investors; when you see no differentiation in selling between assets that should be affected by a factor and those that shouldn’t. As mentioned in our article on low oil, there is a silver lining for those looking; cheaper prices at the pump means more money for consumers to spend on other stuff. Several investment research firms aren’t writing off this year just yet as the fourth quarter is historically when the majority of retail spending takes place. With more money available due to low oil, we could experience tremendous sales and profits, if people stay optimistic and feel like spending this holiday season.
Lastly, the world has been awaiting the U.S. Federal Reserve to leave the crisis policy of zero percent interest rates for the first time in nine years. The head of the Federal Reserve, Janet Yellen, has said that based on the data, the Fed would be ready to raise interest rates when the data was right. They have been looking for inflation near its target of 2% and unemployment of around 5%. With both of these measures within eyeshot, many felt the Fed may raise their benchmark rate in September, but they didn’t. Pimco refers to this as the “phantom rate hike” as the markets’ response was as if it actually occurred. The interesting point is that if the market responds as if the Fed raised rates, it makes it less needed for it to actually raise rates. The market volatility that started in August, set off by news of the slowing Chinese economy, almost certainly weighed into the Fed’s decision. Some reluctance was related to the low commodity prices’ effect on inflation in the future. Additionally, when the rest of the world drops interest rates, as they currently are, the U.S. dollar is strengthened. This historically has put further downward pressure on rates, commodity prices, and inflation. Our view is that unemployment rate in the U.S. has strengthened to the level the Fed was hoping to see. Outside of energy and commodity prices, inflation is in a healthy range as well. Many feel that there is still a chance the Fed will raise rates before year-end, but the longer this market volatility continues around the world, the more reluctant they will probably be at lifting off zero, which is a policy that has never had to be exited. Whenever that occurs, our current view is that we will be in a low interest rate environment for an extended period of time.
Positive corporate earnings, outside of the energy sector, were overshadowed by China, low oil, and rate fears. The good news is that when investors have been focused on bad news, it is much easier to have positive surprises to lift markets. The fourth quarter has historically been a period in which this can happen. We continue to keep an eye on signs of over-borrowing, over-spending, and over-confidence, which historically are warning signs of recession, but those measures are not particularly worrisome today. Now with valuations back cheaper, we remain optimistic about the longer-term. Smaller companies have tended to benefit from less strong-dollar exposure, but still remain more expensive on a relative basis.
Last quarter, the fear of the day for developed foreign markets was Greece. Earlier this year Europe had started to show signs of growth and with cheap oil, a cheaper currency, and low interest rates. They had significant wind at their backs and markets were performing well until fears of a Greek default chilled markets. We do not pretend that Greece’s problems are gone, but the market, in our opinion, has rightly put that to the side for the time being. However, while the U.S. is less effected by the slowdown in China, investor confidence in European growth appears to remain fragile and people have voted by selling equities. It is important to remember that developed market growth historically has been most impacted by service-oriented areas, rather than manufacturing, making it less exposed to the export cycle. Signs in the service-oriented areas in recent months have been encouraging and with a continued favorable environment for companies (cheap currency, cheap oil, low interest rates) we are optimistic, in the longer term, about an international developed market recovery.
Emerging Market Stocks
With all this discussion over China and low commodity prices, it is no surprise that Emerging Markets have struggled. As an asset class, Emerging Markets are heavily influenced by the three C’s: Capital, Commodities, and Currency. All of these items are factors that are closely related. Capital flows in and out of countries’ based on investor views of risk and return. The difference with emerging markets is that this capital flow is a much larger percentage of their total investment pool and there is a “fast money” mentality with this capital which has tended to lead to higher volatility than developed markets. Many emerging markets are commodity producing countries, so low commodity prices disproportionately impacts their economies. Lastly, the amount of capital flow impacts growth which is effected by commodity prices which in turn moves the currency. The lower the currency, the more this impacts capital flows. This has in the near-term caused a negative feed-back loop, but it is important to remember it can work in reverse. A few things to consider are: commodity prices are at very low levels (some might be unsustainably low), the dollar has already substantially strengthened (the magnitude of further increase is likely less), and over time capital will search for returns by seeking out low valuations and higher rates of growth (and Emerging markets are much cheaper and growing much faster than their developed counterparts). The near term voting machine has reason to not like Emerging Markets, but the longer-term weighing machine is signaling us to maintain some exposure to this asset class.
We have long lamented that the future of bond returns is likely low, but have advocated that the purpose of bonds in a portfolio is still one that is needed. The primary purpose of bonds is portfolio stability in times of stock market volatility. In general, higher quality bonds have lived up to their billing and provided a buoy effect (going up when stocks go down) this year. We do expect that some of this may reverse if equity markets recover, but we view this action as exactly why bonds still play a key role in a portfolio. The one area that did not react favorably is the high yield bond market, which has approximately a 15% exposure to energy/oil-related companies. We feel that the fear of defaults in this sector has caused selling across the whole asset class in a somewhat indiscriminate manner and yields reflect expectations of default rates that are significant. This fear of the asset class may dissipate as people have time to assess the real risk in each company.
This term refers to strategies that seek to perform in a different manner than traditional stock or bond managers, whose funds are typically tied to a particular asset class. Returns in diversifying strategies are as diverse as the strategies and risks these managers take. Some of these, such as Absolute Return managers have performed well this quarter and year-to-date and accomplished their goal of a positive return in any market environment. Other strategies like hedged equity and global macro in general struggled recently due to the broad selloff in assets (not differentiating “good” and “bad” stocks and bonds) and some of these funds have exposures in Emerging Markets and/or have heavier exposures to certain sectors of the market which underperformed in the quarter. However, we still feel using these three pillars – stocks, bonds, and diversifying strategies – can provide the opportunity for a greater diversification with potential to both reduce risk and enhance returns over the long-term. As a side note, some investors use Gold as diversifier as it often can protect in market selloffs (if you listen the radio you hear this often). Gold (represented by ETF ticker GLD) is down 6.97% year to date and is down an annualized 14.79% per year over the past three years, which illustrates that Gold is not a panacea, even in volatile markets.
In times of volatility, it is easy to want to vote with your dollars and follow the crowd to reduce risk and wait for bluer skies, but we choose to stick to our guiding principles as we take our role as stewards of our clients’ finances very seriously. We believe that the thoughtful and careful construction of a globally diversified portfolio tailored to the risks our clients are willing and able to take is the prudent answer. We also recognize that volatility works in both directions and that market downturns and rebounds are not announced in advance. For this reason, we aim to remove emotion and weigh the fundamentals to make our investment decisions.
We appreciate your trust in us as your partners in working towards your goals. Please let us know if you have any questions.
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