Market Flash Part II

The wild ride continues today.  As I’m sure anyone with so much as a radio has heard, the Dow Industrial Average opened and promptly sold off almost 1100 points.  Regardless of who you are or what you do for a living, that’s not easy to watch.  After bottoming within a few minutes after the markets opened, the major indices quickly cut those losses significantly.  It’s still going to be a crazy day, and likely week, for stock investors.

This is all being driven by the topics we wrote about Friday but probably is worth diving into a little deeper today.  To start with, it’s worth saying that an investor should never trade in a volatile market like we’ve had today. Traders on the other hand, (good ones), love days like this. 

I would define stock investors as people who are buying equities based on multi-year trends and fundamental analysis.  They are reasonably expecting to see the share price change over time based on average increase in earnings (per share profits) of that stock or group of stocks (index) over their holding period.  For that expected increase to hold true, the average must be realized over at least several years. This is because funny things can happen in any given year or two, but seldom over longer periods of time. 

It is also important to understand what you’re buying when purchasing a share of stock.  The share price should represent the current value of all the future profits of that company.  If you’re buying an index, like we do, then it would be the future earnings of all the companies in that index.  For the share price to go up, the earnings must grow year over year.  The earnings growth of an index tends to be fairly predictable and this is why we view them as a safer way to invest than buying individual stocks.  Something unexpected can happen to one company that can impair their earnings for a long time. 

The biggest risk to stock investors usually comes from themselves.  Everyone knows that to make money in stocks you need to buy low and sell high.  However, most people’s natural instinct is to do just the opposite.  They see a big move in the markets and feel like they need to do something about it.  The reaction today would be to sell when the Dow was off 8 or 9 hundred points.  Two hours later the Dow is off 300.  By being “safe” they just lost a 3% spread. 

Days like this are for traders.  Traders love these markets.  To be successful, traders need volatility.  The more volatility the better their chance to profit.  It’s also fraught with the potential for losses.  But that’s the game traders signed up for.  To be a successful trader you want to look for stock prices that have become disconnected with reality or where there’s a big imbalance between buyers and sellers that you think will get corrected in the coming hours.  These opportunities are hard to find during normal trading days, but plentiful on days like this. 

So let’s look a little deeper into what’s driving the stock market lately.  We had mentioned Friday that the markets were taking their lead from the events in China.  The reason for this is that China wields a significant amount of influence over global trade due to their 1.4 billion person consumer base and $11.2 trillion GDP.  With those sort of numbers, it’s hard for businesses not to have some level of contact with them. 

As China’s influence has grown, so have the concerns about them.  We live in a very connected world and you can’t help who you’re competing with.  A U.S. auto manufacturer has to compete with a Chinese manufacturer for the same steel.  The same holds true for the Indian power plant buying coal or a Japanese firm buying semiconductors.  Firms also don’t have to sell directly into the Chinese market to be effected.  Their product may be one part of something else that is sold in China.  Chinese firms are out there bidding up prices on parts and materials that are used worldwide. 

One of the biggest concerns is the lack of transparency in the country.  China is ultimately a communist country with very loose standards when it comes to laws and regulations.  Economic news and statistics are carefully filtered by the government so no one is really sure if they can trust the official information released – assuming it even is released.  This makes getting at the truth a bit of a guessing game and analysts have become very creative at figuring out what is going on. 

The current drama is centered on the health of the Chinese consumer.  We know that individual debt has been rising in the country and that many Chinese investors have lost significant sums of money in their stock market this year.  We know the situation is bad because of the extraordinary measures their government has taken in an effort to reverse those losses.  In a true central planning way so common in communist regimes, the government has placed a number of trading restrictions and purchasing plans in place to stem the flow of losses in those markets.  This combined with a currency devaluation by their central bank have failed to turn the situation around.  Thus the global markets worry that things are spiraling out of control in China. 

Financial markets loath uncertainty and there is a lot to be uncertain about.  Thus we have a global selloff in stocks.  Our view is that the response is overblown.  While these concerns are legitimate, when you put the numbers to the possible outcomes, the economic impact to our economy doesn’t justify the level of panic we’re seeing.  This feels like a purely news driven event and not one based on the fundamentals.  History has shown that those types of selloffs tend to reverse themselves quickly.  This in no way looks like the last correction we had in 2009. 

Market Flash August 21, 2015

The Return of the Summer Swoon

By Charles Webb

It’s August.  That means it’s that traditional time of year when the stock market sells off and the financial news commentator’s favorite term, “market correction,” starts to get thrown around in earnest.  The reasons for the declines are seldom the same, but oddly the season seems to be connected somehow.  This year’s selloff has been brought to you by the Chinese. 

The world’s second largest and fastest growing major economy is beginning to show signs of age.  Just as trees don’t grow to the sky, national economies can’t exhibit rapid growth forever. They begin to reach maturity at some point.  China’s GDP is expected to reach $11.2 trillion this year.  That’s up from $10.4 trillion last year or up 6.8% (calculated in yuan), but well below the 2014 increase of 7.4% and 7.8% in 2013.  Their latest 2016 GDP forecast is looking for a 6.3% increase. 

Clearly, China’s size is making it difficult to sustain the growth rates we’ve seen in the previous years.  To be clear, 6.8% is still twice what a healthy and mature economy typically grows by, but it’s the trajectory that is catching people’s attention.  There have also been a number of questions raised in recent months about the health of several key segments of China’s economy.  Most notable of those are the number of bad loans sitting on the books of China’s banks.  How much? No one really knows what the truth is, but it’s probably big and could challenge their banking system. 

Experience has shown that this could have a substantial effect on China’s GDP for several years.  These concerns are reminiscent of our own debt crisis from a few years ago.  Large write-downs impair banks’ ability to lend, growth fueled by debt dries up and then a recession ensues.  There wouldn’t be the contagion to other countries like we had in 2008, but the impact would surely be felt around the world due to China’s trading influence. 

All of this leads to the question of what the impact on the earnings will be of all the big multinational companies that do business in China.  Once again, it’s hard to tell, but it could be significant.  A good example is Apple (AAPL).  China is a huge market for Apple and this uncertainty has driven their stock price down by almost 20% over the past month.  Apple has the largest market cap of all U.S. companies and thus is the biggest component of the major indices.  It’s easy to guess what a 20% decline in the largest member of an index will do to that index. 

Just as Apple’s business would be impacted by a Chinese slow down, others would be impacted, too.  And it’s not just companies that sell to the Chinese consumer but also companies that sell into their manufacturing base.  Materials and energy firms are taking the biggest hits this month.  As you can imagine, China has been a huge consumer of those materials and responsible for much of the prices of those goods.  A possible slowdown in their manufacturing base would obviously lead to a decline in raw material costs.  That’s not a bad thing for consumers but the companies that produce those materials also trade on the stock exchange. 

We’re also headed into September when the Federal Reserve has stated that it’s likely they’ll start raising rates.  If August continues to decline, they may hold off on that move.  That would be a powerful counter to the earnings concerns. 

What we are witnessing is the market trying to reprice these possible outcomes.  As with every large market move, the initial market reaction is to sell first and figure it out later.  There’s no telling where things will settle out, but you can be sure the reaction will always be overblown.  Our view is that while these concerns are legitimate, the market reaction is based on sentiment and not the fundamentals.  We still think that stocks will finish the year with slight gains.  As of this writing, the S&P 500 is down YTD about 4%.  It’s down a little over 7% in the past 3 months.  So a 3 or 4 point swing around breakeven is certainly not out of the ordinary and certainly something that can swing back the other direction within the coming 4 months. 

Today, (8/21/2015), the Dow Industrial Average has traded as low as -530 points.  That feels scary.  If our clients had to sell into this market, it would in fact be a big deal.  If you’re not in that position, however, this really isn’t so bad.  The market is basically where it was last October.  I don’t recall any of the news commentators worried then.  These days are far more relevant to stock and options traders.

This is just part of being a stock investor and also why we own bonds and other income producing securities that aren’t correlated with the stock market. In the meantime, we’ll sit back, collect our dividends and add to our positions at lower prices.  I doubt that in 5 years anyone will remember what the stock market did today any more than what the weather was.