Dear clients and friends,
Everyone I spoke with this year has started their conversation by asking, “How are you?” and expecting me to mention the declining stock market. When I responded with, “fine” or “great”, they usually asked, “How is that possible?” Well, I can’t be sure why my perverse reaction implies that I am out of touch with current events, but I can explain why it seems somewhat normal to me. To be certain, I am aware of the recent market decline. Moreover, I am worried, confused, and even fearful. This isn’t the first time that I have experienced market declines since my first job in the trading department as a teenager, obtaining my securities license over 40 years ago, and studying the market history for many years and learning from both good and bad decisions. Additionally, as a successful prosecutor I learned how to deal with adversity because I had to convince all twelve jurors to win a conviction. The defense needed only to convince one juror to succeed. Market declines are challenging, exciting and less competitive because nobody has a crystal ball to see future events. Of course, I prefer rising markets and increasing profits, but the exhilaration of the competitive challenge during inevitable market declines is still exciting to me.
It is important to first understand what happened with this recent market sell-off, consider the cause, and decide if it is a normal market correction or the forecast of a recession. Depending upon your interpretation, what action should be taken? The main three options are to sell, buy, or do nothing. Some do nothing because of confusion. Others come to the same conclusion as a positive choice. Doing something is more satisfying than doing nothing, but we chose patience for reasons explained below.
We believe that this decline is not the result of systemic economic risk like the cause in 2008. During huge market declines as in 2008 and 2000-2002, we sell aggressively to minimize losses. During periods of more normal market volatility with 5-10% declines, we either do nothing or increase our cash position by selling some equities to reduce risk. We don’t try to time the market by selling and then buying back because we don’t believe it is possible to skillfully do it consistently. The January 2016 decline may be the largest historical January decline, but at this point, we think it will be within the range of normal corrections. Why?
Our economy and currency appear to be the world’s strongest and most stable. The primary causes seem to be limited to the energy sector and China. The oil sell-off from close to $110 per barrel slightly over one year ago to almost $26 per barrel this week has serious global implications and has been a drag on stocks in the S&P 500 index. Still, most sectors in our economy have been stable and improving. Inflation and unemployment have been low. The Federal Reserve finally increased the interest rate by 0.25% on December 31st, demonstrating confidence in the economic recovery. Secondly, problems in China affect our market. The Chinese accumulated huge debts to stimulate their economy. There is fear that if their economy slows, they won’t be able to service their debt and may be compelled to devalue their currency to spur both growth and exports.
Why don’t we believe that the market decline will result in a recession? Ultimately, we will have another recession, but not just yet, because the headwind for stocks is explainable by the oil decline, inflation decline that lowers long-term expectations, and implied numbers for corporate sales, earnings, and dividends. Even though stock valuations decline, there is little change in the real economic growth. Corporate growth rates, profit margins, and valuations may decline as labor costs and wages increase. Nevertheless, higher worker incomes will likely increase personal spending and stimulate the economy.
While investors prefer easy answers, the causes of and solutions to economic problems are varied and complex. The U.S. domestic economy and market must be viewed in the context of the global economy. The joke a few decades ago was that when the U.S. economy sneezed, the world caught a cold. Today, we are considerably less dominant globally and events in China, Japan, Europe, and even the emerging markets affect our economy and must be considered. The largest and most stable companies today have become more global and have earnings exceeding well over 50% from doing business overseas. In periods when our dollar is stronger with attractive exchange rates for other currencies, our largest companies face headwinds for exports because our products become more expensive to foreigners. Conversely, imports for Americans are cheaper, creating pressures for our local companies to reduce prices to compete.
So if this is not a time to sell, has the 10% market decline created a buying opportunity? If the decline is over, the answer is yes. If this market volatility continues for a few more weeks, we may not have seen the market bottom and lower prices will appear ahead. As stated above, with no crystal ball everyone has an equal chance to predict the future. Stock prices today are much lower than a month ago, but they could reasonably become cheaper. By historical standards, according to FactSet, U.S. stocks as measured by the Dow Jones Industrial Average are currently valued at 1.4 times annual per-share revenue, but the average since 2001 is 1.3 times revenue, so it is possible that stock prices will decline further. (Arends, 2016) This may be a buying opportunity, or it could be a temporary stop before this decline reaches its unknown destination. This uncertainty is called risk.
Our interpretation of the data is that the correction is very scary but still within normal ranges. The data is not predicting a bear market or recession, so we are not selling (except for about 5%), nor are we smart enough to really know if this is a market bottom. The risk of that uncertainty gives no comfort to buying today and hoping for the best, so we are not buying. We believe that further declines will be limited but the potential for a substantial recovery in the near future will be great, so we choose to remain patient. If we are wrong in our forecast, we will take swift actions to reduce equities. If we are correct, the losses will be quickly erased with the probability of greater gains ahead.
Our approach is not without risk and our experience does not prevent constant concern and worry about the correctness of our decisions. We have enjoyed past success but there is no arrogance because each market event is different and history never repeats itself exactly. Still, the challenge and excitement of slaying the market dragon is always present as a motivator.
As always, I thank our clients for their support and loyalty during good and bad times. Since we get fewer phone calls from worried clients during each market decline, we prefer to believe that our past decisions have brought some confidence and comfort. With best wishes for better days ahead,
Your designated worrier,
Marv
Marv Kaye, J.D., CFP
References
Arends, B. (2016, January 21). Retrieved from Marketwatch: http://www.marketwatch.com/story/look-out-stocks-might-fall-a-lot-further-2016-01-21
