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.