Market Update

January 14, 2016

We are sending this note to give you our perspective on the recent global market turmoil and volatility.  We realize these periods can be very unsettling and stressful.  It’s difficult to keep your cool when the 24/7 news cycle is on high alert as these events unfold.  While there are legitimate concerns about the global economy, we believe the pessimism is significantly overdone.

Why is there such concern?  The concern is specifically that the recession in emerging market economies will spread to the developed world, including the U.S.   That seems understandable given the notable weakness in economically sensitive sectors such as basic materials, energy and industrial cyclicals, a result of a weakening global economy and a strengthening dollar.  Commodity dependent emerging market economies (China, Brazil, Russia, Mid East etc.) have been particularly hard hit.

Investors are especially concerned about the global economic slowdown beginning with China.  China’s slowdown has had a disastrous impact on commodity centric emerging market economies. The bottom line is that as China’s economy has slowed, commodity demand has evaporated; this coming off of many years of commodity hoarding by China.  Couple that with an explosion of new oil production and reserve discoveries brought on by technological innovation in this country, specifically fracking, and the world is awash in oil, just as demand has begun to decline.  Commodity oriented groups and sectors have been smashed.

First, some perspective.  The equity markets have risen steadily since the 2008 credit market collapse with few interruptions.  It is normal to experience corrective periods to consolidate gains and reset investor expectations to more normal levels.  At the same time, the equity markets are essentially futures markets and what is being priced-in today are events that investors expect to happen in the future.  Now that the average stock is in bear market territory (down 20% from its recent high) investors are clearly pricing-in a recession.  We think that’s way too negative.  Why?

The Market

The normal ingredients for a prolonged bear market simply do not exist right now. What are those ingredients?

Excessive Speculation/Euphoria

Bull markets operate in four phases.  Fear (think early 2009 period as the market was in full collapse), disbelief (the early phase a new bull market, investors still believe it’s a temporary recovery), acceptance (thought process moves past fear and investors start to think it’s time to get on board), euphoria (there is a fear of missing out, excessive speculation enters the market).  The euphoric stage precedes a major long-term bear market and typically coincides with excessive valuations and a “buy at any price” mentality.  Think 2000 technology bubble or the 2008 housing bubble.

We simply have not seen excessive euphoria in this recent bull market.  In fact, investors have been extremely cautious in their behavior still poisoned by the 2008-2009 bear market.  Since the 2009 low, investors have never moved out of the disbelief/acceptance phase.

Excessive P/E ratios

While the P/E ratio for the market is not super cheap, it is certainly not high by historical standards.  The 12 month forward looking P/E currently stands at a reasonable 15.

Interest Rates

Bear markets can be triggered by rapidly rising interest rates.  That is clearly not the case right now.  While the Fed did finally raise the Fed Funds rates by a quarter of a point, interest rates are still at historic lows and given the economic backdrop it will be an extremely slow process back to normalization.

The Economy

Long-term bear markets also signal an impending economic recession.  Investors quickly “price-in” their expectations and therefore a bear market typically begins before a recession.  Investors sell now and ask questions later.  We believe the backdrop does not support the case for a recession.

It’s important to remember that the U.S. economy is no longer a manufacturing economy but has transitioned into a consumer and knowledge based (information technology) economy.  The consumer represents 70% of our economy at this point. And the consumer is well supported right now.  How?

Low Rates

Despite the rate hike in December, interest rates are still extremely low by any historical measure.  This might be bad for savers, but very good for consumers.  Borrowing costs are still extremely cheap.

Energy Costs

A recession has never started while oil prices have declined.  And right now oil prices have collapsed from over $100 to under $30 a barrel in less than two years.  The impact of this cannot be overstated.  This could be the single biggest boost to the economy for the next several years.  Cheap oil benefits all Americans.  In fact, the average American will receive the biggest proportionate benefit as less of their discretionary income will be committed to heating and fuel costs, leaving more money for them to save or spend, or both.  Think of this as a massive tax cut for every American.

A client of ours bought a round trip ticket to Florida for $68 recently!!

Full Employment

While the economic recovery has been uneven, it has added new jobs at a quicker pace recently.  Unemployment now stands at 5%.

Strong Dollar

While the strong dollar will be a head wind for global companies, particularly manufacturing and heavy equipment (think Caterpillar tractors, the strong dollar makes their equipment more expensive on the global stage), it will be a strong tail wind for importers.  And the U.S. is a net importer.  This is what China is counting on as their manufactured goods are now less expensive.  Once again the consumer will benefit from this scenario.  Each dollar will stretch further.

Yield Curve Inversion

Each recession since the 1970’s has been preceded by an inverted yield curve (long-term rates less than short-term rates).  Once again this phenomenon is not in place currently and is not even close.

While there are legitimate concerns about the global economy, we think it’s overstated.  And while China is important, it is less important than most believe.  Its impact will be felt most especially in emerging market economies and in the commodity and industrial cyclical sectors.

The recent volatility and price setbacks have been difficult but now is not the time to panic.  Expectations are overly pessimistic in our view and as contrarians we believe now is a time to buy, not sell.   Having been through these periods before the best advice we can give is to stay with your long-term plan.  We know that equity investors will be rewarded in the long run and with few attractive alternatives today, equities offer the best choice.

As always, we are available to discuss our current market thinking or any other questions you might have.

Best Regards,

Bill and Phil Noonan