Market Update–October 26

The past three months have been a troubling time in the markets.  If you were to listen only to the financial media, you might believe that China is falling apart at the seams, the U.S. economy is tipping into a recession and El Nino is about to push California into the Pacific.  However, the reality is very different from this perception.  There are many issues to raise alarm in the current market environment, but the fundamental core of the economy continues to show signs of strength.  The volatility of the markets, however, has been severe and worrisome.

As I write this update, the market just completed a late summer gyration of down -10% and then up +8% to get back to its starting point for the year.  While zero growth in the stock market may sound benign as compared to mounting losses, the volatility has been unlike any we’ve seen since 2008 and the source of much of this public concern.  More important, many sectors of the market have seen near collapse this year, as we will discuss, and the large funds are suffering.  We will not see the final fund returns until the end of the year, but interim reports show many large funds posting excessive losses for 2015 triggering further selling.

With conflicting or incomplete data, the factors causing this disruption in the market have been elusive to both the experts, and me, though there are some likely explanations.  One of these centers on the impact of hedge funds and electronic trading on the markets and the volatility it can create.  I will also discuss the Exchange Traded Fund (ETF) market and the tensions created by its rapid growth in so many directions at once.  Meanwhile, asset allocation strategies are also facing an impending shift. The end of Fed stimulus programs last year, the expected rise in interest rates, and a slower-growth China are all factors that will contribute to a change in the investment landscape and an important shift in money management allocations that follows.

 

Screen Shot 2015-10-30 at 11.55.44 AM

The Headlines

The summer and early fall brought news about the slowdown in China and fears of its impact on the global economy.  Their central bankers acknowledged these issues when they devalued the currency in August, triggering the first spate of market volatility. While China has grown to become the third largest economic region (behind the U.S. and the European Union), the pace of its growth makes it the largest single contributor to incremental demand. The chart below shows the relative size of the major economies, and the impact that Chinese growth has on global consumption.

With consumption representing roughly half of all economic activity, global growth is highly sensitive to this dynamic in China.  The economy needs to maintain some growth in order keep the existing job base, and also to expand that base as the working population grows.  Those incomes lead to spending, generating both demand and wealth.  Trends such as the growing middle class (and indirectly, increasingly stable political environments) are directly rooted in this process.  As an example of this process, look at sales of iPhones in China, and Apple’s marketing plans there.  China is going to be the largest iPhone market for Apple this quarter.  If China isn’t buying as many phones, Apple doesn’t hit their growth targets on which investor expectations are built.  It is far from the end of Apple if his happens, but with a market on edge, there is no room for such a miss with Apple.

Screen Shot 2015-10-30 at 11.56.25 AM

Screen Shot 2015-10-30 at 11.56.37 AM

The world’s production and supply of everything from raw materials to iPhones is based on projections for demand.  With China growing at 7%, you need “X.”  With China growing at only 5%, you need significantly less than “X.” That is the problem right now: China is still growing, it is just that the forecasting done two years ago was overly ambitious, and the world’s supply chain was built for more. 

Over the past twelve months, the oversupply in raw materials has resulted in precipitous drops in prices.  Whether the price action matches the true oversupply or reflects the exacerbating impact of financialization is a dynamic that will play out in the coming months.  Financialization continues to expand as derivatives products of all kinds expand access to each of these markets.  For instance, each barrel of oil that is generated each day is bought and sold 26-times by the end of that day.  Minuscule manipulations in the price of that barrel and every other barrel can have an enormous impact on the market for oil.

The oil price drops have had devastating impacts on energy companies, ripping out their capital expenditure budgets and causing growth to slow in related sectors. The clearest example of this is the contraction in the industrial sector as oil companies have less and less incremental spending – and we are sure to see this anemic growth continue. Take, for instance, Caterpillar (CAT), which supplies mining equipment to mines and combines to wheat growers. Facing lower prices across the board, the first measure producers take is to cut capital spending and delay replacing old equipment.  CAT took a beating earlier in the year because of this dynamic.  In late September, they took another beating when they announced the immediate implications in terms of employee cuts.  One could argue that this is an opportunity for the company to cut excess and to be much more profitable when demand resumes, but that is lost on the market in a trading environment that is hostile to deviations from expectations.

Reality Check

The reality test is to look at economic indicators, and how those indicators have been trending.  China’s data is not always accurate, which creates uncertainty, and the market abhors uncertainty.  The U.S. has the opposite problem.  From our massive government infrastructure for reporting data to private drones mapping growing activity, we are flooded with information.  The following charts are the ones that we like to look at most closely, and the trends are consistent with a year ago.

Screen Shot 2015-10-30 at 11.56.57 AM

Screen Shot 2015-10-30 at 11.57.10 AM

Trading Dynamics
What is troubling is the turbulence of the recent market correction. The chart below shows the VIX – a measure of expectations of future volatility – since 2008.  Namely, after China devalued their currency, the VIX moved to levels that we haven’t seen since October of 2008, when things truly were a disaster in the world and the economy was falling apart. While the economy was vastly different in August then it was in 2008, it takes far less to drive volatility to those levels.

Since 2007, we have seen a number of events, pretty much on an annual basis, in which volatility spikes to levels that are typical of once-in-a-decade events. The volatility swings of 2008 were the first; the Flash Crash of 2010 was another, Black Monday 2011, gold in 2012, the Swiss Franc in 2014, and now the S&P 500 with commodities this past summer.  The underlying situation is typically the same – the market moves in a manner that has no bearing on the economic fundamentals.

Screen Shot 2015-10-30 at 11.57.22 AM

The way trading technology has evolved lockstep with financial engineering is one of the more cogent of possible explanations for the dislocation.  High frequency trading allows thousands of trades to be executed in nanoseconds to capture minuscule profits at massive scale. Financialization compounds the problem.  But Exchange Traded Funds (ETFs) are starting to take center stage, as a growing and significant portion of the daily trading is related to these funds.  While there is no definitive evidence on the topic, it appears that ETFs were at the center of the Flash Crash and the gold collapse.

Monday morning, August 24, is a good example of this dysfunction and the impact of ETFs.  On the prior Friday, the market had lost 3%.  Monday morning, it looked like the market was going to lose another 3-5%.  The ETF market, where a massive amount of retail money is invested, was frozen.  Quite literally, over 1,000 individual ETF issues could not trade.  And when they did trade, the execution was up to 30% away from the underlying securities.  For reference, ETF’s rarely trade more than 0.1% away from the underlying index value.

Screen Shot 2015-10-30 at 11.57.34 AM

We have three factors that have weighed heavily on the long-view investment managers who control the bulk of long-term public investments.  First, as you might recall, the quantitative easing program by the U.S. central bankers ended with its final block of buying in October 2014.  The Fed has effectively stopped printing money, removing the ‘methadone’ for the market.  While the Fed has yet to remove this liquidity from the market, it is still a significant change of flows.

Next, we have the imminent increase in Fed borrowing rates that will take place either this fall or into 2016.  It was over nine years ago, in June 2006, when we last saw these rates rising. That is a dramatic change for an industry that is heavily populated with young traders and managers.  The Wall Street Journal reported that Minneapolis-based U.S. Bank estimates that 70% of employees in impacted positions haven’t experienced a rate hike – a phenomenon exacerbated by layoffs that followed the financial crisis.

The final factor in the sea change is China.  While they are still growing and will likely do so for a long time, the tapering of that growth has dramatic implications for commodities, and subsequently industries that support commodities producers.  Factor all this together, and you have an environment in which long-term asset managers are using new allocation strategies that will take months to deploy.  The first step in that reallocation it to sell existing positions.  Later comes the buying, that lag driven by the perception of current market volatility.

Looking Ahead

Given the absence of key growth drivers, we expect to continue to see a stable but slow growth domestic economy, without inflation, and a Europe that will benefit from a weaker currency and their own central banking stimulus programs.  The jobs data continues to show a low level of unemployment claims with modest jobs growth.  Corporate earnings have not come far short of expectations, but are not creating too many surprises to the upside either. In essence, the fundamentals are pretty solid and not yet giving anyone reason to turn instead to risky assets.

The strong dollar and the related increase in the cost of our exports doesn’t help matters, but with the Fed rate policy is such limbo, the dollar may start to lose some value this winter, helping that sector of our economy.  We also see significant upside in the price of oil given the irregularities in reported demand by the IEA.  Any prolonged spike in oil prices combined with a weakening dollar would be a tremendous boost to both the energy and industrial sectors in the U.S.

The use of individual equities in this volatile market environment is key to generating strong returns.  Companies that possess strong growth potential or are beaten down simply because of the systemic fears in the market or in their particular sector – rather than individual fundamentals – are our focus.  The carnage in the healthcare sector this month was a good example of all companies getting punished despite any resilience individual companies may possess in their respective markets.

Furthermore, a continued focus on non-equity assets classes will help to stabilize portfolios through the uncertainly.  Held-to-maturity bonds continue to be a strong income driver, while alternative investment strategies around private pooled funds continue to perform well irrespective of market volatility.  In essence, the basics of investment for value and long-term horizons become far more important in this environment than any short-term play on market volatility.

In the mean time, all the best for an early start to this winter and a spectacular fall foliage season.

Regards,

David B. Matias

sig

Managing Principal