The Slide Continues

We've yet to have any relief from this year's global selloff in stocks. Three weeks into the year and both the Dow Industrial Average and S&P 500 are down roughly 10%. The decline in the U.S. markets is being led by international markets - specifically China and world oil prices.

China's slowdown has investors nervous about the impact on the economies of their trading partners. The Chinese government has proven to be incompetent or untrustworthy in managing their financial markets, currency and economic statistics. So trying to quantify the potential effects abroad has become a bit of a guessing game. As we've mentioned before, the markets hate uncertainty.

Additionally, the resulting decline in commodities prices is causing serious concerns for countries whose economies are primarily built on raw materials exports. The decline in oil prices is the most significant problem for these countries and has the biggest potential to lead to political destabilization. Adding to the worries is the fact that sanctions on Iran are being lifted this week and thus they are now able to sell their oil in the open market. This will only add to the over supply problem.

So should you worry about the stock market? The answer is based on who you are. Participants in specific sectors of the energy industry are, and rightfully should be, worried about their business. The underlying forces that have driven down oil prices are legitimate and likely here to stay for the next couple of years. We doubt the sub $30 per barrel prices are sustainable, but it will likely be a long time before we see $60 (let alone $100). Our thesis has always been that, on balance, cheap oil is a good thing.

 

For the rest of us, this selloff should be seen as a less significant event. It's important in times like these to separate the stock market from the fundamentals. Ignoring the stock market, things look a lot better here in the U.S. We've had pretty good jobs reports the last few months. GDP has been steady and early in the earnings season, corporate profits have been healthy. So we don't view this sharp decline as being driven by the fundamentals.

Instead, this month's market decline appears to be driven by fear and selling pressure from outside the U.S. Our experience has been that these headline driven events tend to be short lived. This is especially true for equity portfolios such as ours. Almost all of our equity positions are constructed using securities that track major indices whose performance is a function of U.S. economic health. We're not making bets on specific sectors of the economy or industries. Therefore, we expect these investments to look past the news and respond to the data over the course of the year, which takes us back to the subject of oil.

Energy costs account for a significant part of everyone's expenses. It's hard to see how a reduction in costs is a bad thing for the rest of us.

A Not So Happy New Year

Technically, this commentary should be about the markets in the fourth quarter, but the real news, and I'm sure what's on everyone's minds, is the selloff in the stock market in 2016. First, we'll dispense with the fourth quarter results.

After a rough third quarter, stocks found their footing in the remaining months of the year and were able to retrace their losses from the summer. The major indices all finished within a percentage point or two of each other at around break even for the whole year. The total return (price change and dividends) for large cap stocks gained about 1% while the small and mid-cap groups were down about a point.

We had felt going into the year that 2015 was going to be a so-so year. These results were slightly lower than we had anticipated, but still mostly in line with our expectations. The volatility was largely driven by renewed concerns over Chinese GDP and the impact of their slowing economy on global trade and commodities demand. This, however, was really more of what we'd call a "headline risk". What we mean by that is the concerns were more about fears over what may unfold in the future as opposed to actual declines in earnings during the year.

The real news in 2015 was that the Federal Reserve officially kicked off their long awaited rate hike campaign. The first interest rate increase was only 0.25% (coming up from zero), but it signaled the official end of the easy money policies and Fed guided market support over the last eight years. This move was long awaited and had been pushed back several times. They probably waited longer than they should have by starting this process last month, but now that they've made their first move, it's expected that they'll steadily continue raising rates for the next few years.

It's believed that the Fed would like to increase the Fed Funds rate up 1% per year for the next three years. This would put the Fed Funds rate at 3%, which is still roughly a point below the historical average. That pace would be pretty aggressive and would be predicated on the stability of the global economy and the U.S. dollar.

This has set the stage for 2016. As of this writing, both the Dow Industrial Average and the S&P 500 are off almost 8% and the NASDAQ is down nearly 10%. Those are very sharp declines in just two weeks. There are three principal reasons for the selloff. In no particular order they are: China GDP, the value of U.S. dollar and the price of oil.

Of the three, we believe the Chinese economic slowdown is the least significant issue. That's not to say that the news isn't having an impact on stock prices, but once again, we believe this is a headline risk and the impact will be overshadowed by other events (good or bad) in the near-term.

The strong dollar is another area of concern for the stock market and is the direct result of the Fed's decision to raise rates. Globally, rates are extremely low and investors are desperately seeking yield.

Higher rates make our debt investments more attractive to foreign buyers and increase the demand for the dollar. A strong dollar, in turn, makes goods and services produced by U.S. firms more expensive abroad. Large U.S. firms derive a meaningful part of their revenues form exports so it's easy to imagine how their sales may be affected by a stronger dollar.

The final market driver of late is the collapse in the price of oil. The price of a barrel of oil dropped below $30 this week. That's a price no one thought we'd ever see again. This rapid decline has put into question a whole host of issues. They range from the impact of political stability in the only functioning governments in the Middle East to the solvency of the high yield debt market.

We're less concerned with the political implications of low oil prices. Most of the oil producing nations are tenuous at best and while low oil prices make the situation worse, they are hardly the cause. More importantly for the stock market is how bad will the energy sector be hit and how will that effect the rest of the economy.

This question is what has directly led to the selloff this year. We acknowledge that there will be a lot of pain felt in the energy sector. There will also be many companies in the exploration business that won't survive this. Many of them have also borrowed a lot of money that won't get paid back and their banks and bondholders are going suffer losses. That is all true. What is also true is that significantly lower energy prices will have a huge positive impact on a much wider segment of the economy and corporate earnings.

We wrote about this last year and named just a few of the beneficiaries of low oil prices. The list is quite large and stretches across the whole economy. It may be a few quarters before Wall Street sees the impact show up in firms' quarterly earnings, but we have little doubt that it will. It's for this reason we feel that these low oil prices will be a net plus on the U.S. economy and the S&P 500 earnings. Therefore, we view this recent decline in stocks as temporary.

Looking ahead at 2016, we think the bigger driver of the markets will be the Federal Reserve. The timing and degree to which they increase rates will have a lot to say about the stock market. Our guess is that they'll take it slow. That being said, any increase is going to be a strong headwind for the stock market. More importantly, the inevitable uncertainty surrounding the Fed's moves alone will lead to a lot of volatility.

As far as the immediate drop in the market is concerned, this is not a long-term selloff because stocks are overvalued. Instead, we think these losses will reverse themselves in the coming weeks as oil prices stabilize. We do expect this to be another up and down year as higher earnings forecast battle rate increases. Our expectation is that this will be another mediocre year for stocks, but we are looking forward to higher rates for bondholders. It'll be interesting to see how the markets stand on their own without the Fed propping them as they have over the past seven years. That's the real question.