Counterpoint Commentary

The Cruel Season

T.S. Eliot famously wrote that “April is the Cruelest Month,” but on Wall Street, it is typically August, September and October that are cruelest to investors.

We are in the Cruel Season, when problems tend to emerge from the shadows to loom larger than life, markets stumble, and hope and resolve give way to fear and doubt.

The Cruel Season

And the global financial markets have been in a doubtful mood of late, succumbing to a growing list of worries. These worries include slowing global growth, China and other emerging markets, plunging oil and commodity prices, diverging monetary policies, and rising geopolitical risks.

Since the middle of August through the end of September, stock prices in the U.S. declined around 10%, and considerably more outside the U.S. Credit spreads widened, with Treasury bonds rallying and high yield bonds falling. Volatility levels have spiked.

Although there are reasons for concern, we think that a number of current worries have been blown out of reasonable proportion and perspective. As we have written many times, your greatest fears and hopes rarely come to pass. People dislike uncertainty and ambiguity and crave simple and binary constructs for looking at the world: black/white; good/bad; left/right; bull market/bear market. Reality tends to reside in the grey and often ambiguous middle ground between the extremes. The challenge for investors as always, is to cut through the fog and noise and connect the dots between actual fundamentals and price.

This too, will pass.

Chart 1
(Click to enlarge)

There is light at the end of the calendar. It is interesting to look at the monthly distributions of returns of the S&P 500 over time. Chart 1 above shows the monthly range of returns for the S&P 500 since the beginning of 1987. Although negative returns can and do happen in any month of the year, they tend to happen with the greatest frequency and magnitude in August, September and October of the calendar year. Typically, investors and markets turn more positive in November and December tends to have the highest returns of any month.

The point of this analysis is not to advocate calendar-based market timing but to underscore that market corrections are normal, especially during this time of the calendar year.

Chart 2
(Click to enlarge)

On Chart 2, we can look back to 1980 and see that over the past 36 years there is typically a correction in the markets every year, with an average decline of 14%. Yet, over the full span of time, including the 1987 crash, savings and loan crisis, bubble, September 11th terrorist attacks, multiple wars, and the “Great Recession,” markets are up over 4600% over that time, or about 11.4% a year on an annualized basis.

This is why it is important to stay invested and focus on the long-term. Every day over the past 37 years, newspapers have been full of scary headlines and mostly bad news. They do a much better job reporting on problems than progress. And yet, progress is a continuous and powerful force. There have always been problems, but problems tend to beget solutions and engender progress. It is the natural tendency for people and economies to grow, recover and move forward. Over the span of years, the stock market reflects the compounded triumph of progress over problems. It has been far more rewarding to invest as an optimist than a pessimist.

Of course, just because corrections are a normal occurrence, like hurricanes, that does not mean that they are enjoyable when you are in the midst of one. You can’t have a decent correction without a good reason and a growing belief that things are going from bad to worse.

But, as we have also written many times, actual and perceived risk and opportunity tend to be inversely correlated with one another. As stocks get cheaper, they tend reflect more of what can go wrong, and less of what can go right. They offer greater value and greater potential for future appreciation, even though they are perceived as riskier. The risk in the stock market was much greater in late 2007 when everything seemed fine, than it was in early 2009, when it felt like the world was ending.

The markets have recovered from every correction, and if anything, the best time to have increased exposure to stocks, was not when the going was easy, but rather, in the depths of the cruel season, when all looked bleak and scary.

Bubbles and Fog:

The biggest fear among investors is that global economic growth is slowing, led by a marked slowdown in growth in China and the rest of the emerging markets.

Although growth rates are lackluster, and we do see things slowing, overall economic global growth is still positive. In addition to the well-known areas of weakness, there are also areas of strength and dynamism.

The global economy is in the process of unwinding two significant investment bubbles; a bubble in Chinese construction spending, and a bubble in energy exploration and production. Each of these bubbles inspired massive investment, largely funded with debt, and created an inflated sense of sustainable demand and pricing.

The China Bubble:

In the wake of the credit crisis in the U.S., China embarked on a massive stimulus program. Much of this money went into construction, causing a spike in demand for raw materials and capital goods around the world. The spike led resource-producing countries and companies to borrow large amounts of money to scale up their operations to feed China’s insatiable demand for copper, steel, concrete, bulldozers and cranes.

This led to a period of robust economic growth within these economies, but a false sense of sustainable prosperity.
The Chinese stimulus program gave the Chinese economy and any economy tied to it a turbo-charged boost. But it was also excessive and somewhat misguided. Much of the money went into unnecessary or wasteful projects, resulting in a sea of empty factories, empty buildings, even empty towns.

Fortunately for China, it has a large and diverse economy. It also has significant reserves to help absorb losses and cushion the transition from a manufacturing and export-driven economy to a services and consumption driven economy.

This transition is already well underway. Manufacturing and exports now represent less than 42% of Chinese GDP, while the services sector is over 50%. Even as the manufacturing sector shrinks, the services sector and overall Chinese economy should continue to grow, albeit at a more measured pace. Caterpillar may sell fewer tractors, but Starbucks, Nike and Apple will likely sell more coffee, sneakers and iPhones.

Unfortunately for many of China’s trading partners, the outlook is much more grim.
This is especially true for resource-based economies that have seen dramatic declines in demand for their exports and at much lower prices. Meanwhile, they are facing huge capital outflows, rising unemployment, unsustainable amounts of debt and excess capacity. It will take a while to work through these issues.

The bottom line is that we think China has a big and diverse enough economy to manage its way through this transition, although it may be a bumpy transition. For many of China’s trading partners, we see more pain ahead.

One bright spot among the emerging economies is India. It has a population of 1.2 billion people, more than half of whom are under 35 years old. Under the reforms of the Modi government, the economy is picking up steam, growing at 5% to 6% a year. It has a strong consumer-driven economy, with little dependence on China. Lower oil and energy prices are a direct benefit to India as they are to China.

The Energy Bubble:

The second investment bubble has been in the energy sector. A few years ago, investors became taken by the idea of an “energy renaissance” in the United States, heralding a new era for U.S. energy production. The renaissance was fueled by the combination of new technologies such as fracking and horizontal drilling, and the discovery of massive new reserves in the U.S. and elsewhere.

Money poured into energy investment, and energy companies borrowed massive amounts of easy capital to finance large new projects.

From a production standpoint, these projects have been highly successful, resulting in a significant increase in oil and gas production, the majority of which has come from the U.S.

But many of these projects were undertaken when oil was closer to $100 a barrel and with the assumption that oil prices would remain a lot higher than where they stand today.

The problem is that the price of oil, like any commodity, is set at the margin. The world is now awash in oil and there is an excess of supply relative to demand. Oil prices have accordingly plunged to around $40 a barrel. Productive capacity is quickly being reduced and supply will eventually shrink to meet demand and stabilize the price. Given the secular change in exploration and production technologies, we think $40 - $50 is a more realistic long-term price for oil going forward.

This is a problem for many companies that borrowed money with the assumption that prices would remain significantly higher than they are today. They are now heavily indebted and overextended and are going to have a difficult time scaling back their operations, servicing their debt and staying profitable. We see signs of this stress in the high yield bond market, 15% of which is tied to energy-related debt.

It is also a problem for countries like Brazil and Russia, for which oil revenues represent a large part of their exports and GDP.

Conversely, the decline in energy and commodity prices provides a large aggregate economic benefit to economies for whom energy and commodities are a significant input cost, such as Europe, Japan and China. We think the benefit to energy users is far greater than the cost to energy producers. Sometimes a headwind in one part of the world creates a tailwind in another.

Back in the USA.

The U.S. has been the standout relative to the rest of the world in terms of broad economic growth. Recent economic data point to some softness, especially in the manufacturing and energy sectors. It is hard to tell at this point if this is just a seasonal or cyclical phenomenon. Meanwhile, the U.S. consumer continues to do well. Housing is strong, and retail, auto sales and travel remain quite robust. The most recent jobs report was disappointing with only 140,000 new jobs created in September, but it still marks solid job growth and the unemployment rate is quite low, at 5.1%.

Multinational companies have been impacted by a stronger dollar, which has made their goods and services less competitive abroad. In addition, companies tied to the production of energy and commodities, or dependent on construction in the developing world, have had a particularly tough time.

But the fear that a significant decline in China and other emerging markets will have a meaningful impact on the U.S. or even Europe is overstated. Direct exports to emerging economies amount to only 2.5% of U.S. GDP.

The other major concern among U.S. investors has been the question of when the Federal Reserve would start to raise rates. We think this concern represents much ado about nothing. Whether the Fed raises rates in October, or December, or next year, the increases are going to be small and the absolute level of interest rates will very likely remain very low for a long time to come.

Europe and Japan:

Europe continues to show slow and somewhat mixed improvement, spurred on by massive monetary stimulus by the European Central Bank, a cheaper Euro and improving confidence. Even Italy, once the runner-up poster child of dysfunction after Greece, just boosted its GDP forecast to a whopping 0.9%!

Europe has a larger trading relationship with the developing world than the U.S., but total direct exports to emerging economies still represent only 5% to 6% of European GDP.

Japan continues to make progress along Shinzo Abe’s “three arrow” initiative including extraordinary monetary policy, fiscal stimulus and structural reform. We expect that the Japanese economy will show positive growth of up to 1%.

Investment Outlook.

Putting it all together, we see a global economy that is growing at a slow, and subpar pace, with notable pockets of weakness – emerging markets, energy and commodities – and notable pockets of strength – especially in the U.S. economy.

There is an excess supply of commodities and productive capacity, and large amounts of debt used to finance the creation of that capacity.

There are also areas of fast growth and innovation, especially in technology and health care sectors throughout the world.
Central banks around the world are still highly supportive of economic growth and fearful of deflation. They will err on the side of keeping interest rates lower for longer, while trying to keep their respective currencies as weak and globally competitive as possible.

There is widespread pessimism among investors. This is actually a good thing. We get more worried when people are either complacent or giddy.

Much of the pessimism, and most of the well-known problems are well reflected in the prices of most securities.

In a world of slow growth and low interest rates stocks still represent the most attractive asset class for long-term investment. On an historical basis, stocks are slightly cheaper than average. Relative to a 10-year government bond yielding 2%, stocks look like a much better investment.

As always, we invest for the long-term and design portfolios to weather the market’s many storms and seasons and benefit from the compounding progress of economies, companies and human endeavor.

In particular, we balance diversified investments focused on areas of long-term growth and innovation with more defensive equity, alternative and fixed income strategies to mitigate risk.

As long as markets remain unsettled, we will likely see higher than normal levels of volatility. These stormy conditions are unsettling but normal. They too will pass.

It is, after all, the Cruel Season. And, as April showers bring May flowers, the cruel season typically leads into a positive year-end, as well as new hopes and new beginnings in the new year.

As always, we welcome your questions and comments.

Jurika Mills & Keifer, LLC
October 2015

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. There can be no assurance that investment strategies referenced will be successful, or that investment objectives will be achieved. The net performance represents performance figures net of all fees including management, performance fees, transaction costs and commissions. Past performance is no guarantee of future returns, which may vary. Please note that one cannot invest directly in an index.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.