“Put your hand on a stove for a minute and it seems like an hour. Sit with that special girl for an hour and it seems like a minute. That's relativity.” - Albert Einstein; 1879-1955
Recognized for creating the world’s most famous equation: E = mc2, Einstein received the Nobel Prize in Physics in 1921. He referred to gravity as the “general theory of relativity”. We will forgo the science lesson but will, instead, focus on both gravity and relativity.
Gravity is simply the force that pulls two objects together. Here on earth it tends to make objects fall. Though Einstein’s work involved physical objects, the stock market (1) can feel the force of gravity as well. Stock prices can slump if earnings (sales minus expenses) sag or the multiple of those earnings declines; both are potential sources of gravity.
The market multiple reflects the confluence of interest rates, inflation expectations and investor confidence. The multiple reached extremely low levels in 2008 (based upon investor fears that financial markets were going to collapse) and extremely high levels in 1999 as AOL, the poster child of the dot-com era, became the 10th biggest company in the market. Today, that multiple sits squarely around historical averages. Thus gravitational risk is counterbalanced by the possibility of levitation.
Earnings, or profits, represent what’s left after all expenses are subtracted from all revenues. Strong drivers on the expense side include raw material costs, interest and wages; all currently appear restrained. That leaves increasing sales as the obvious remaining opportunity to increase stock prices. Some individual companies have the ability to increase sales through superior management that might include successful research, new services or clever marketing. However, in aggregate, for sales to increase, the economy needs to grow.
Between December 29th and February 11th of this year, the U.S. stock market gapped down almost 12%, nearly mirroring the 12% slide experienced last August. Remember that stock market corrections tend to occur, on average, once every 20 months. (2) What was pulling it down?
Roseanne Roseannadanna, the Saturday Night Live character created by the late Gilda Radner, coined the phrase, “If it’s not one thing…it’s another”. The market always seems to have to overcome some gravitational factors. Today, economic uncertainty is the primary focus including:
The Institute of Supply Management tracks the orders for new goods. Economic slowdowns are often presaged by readings below 50. The chart below shows that we are hovering near that worrisome level. (3)
Last quarter we discussed rising credit spreads. The graph below reflects the increasing cost of debt for non-prime borrowers. (4)
Although housing sales continue to grow, permits for new construction fell by 3.1% in February, “driven by an 8.4% fall in multifamily units” (5)
The collapse of oil, from $110 per barrel in 2014 to $26/barrel this February, represents an additional strain on economic confidence. Though energy stocks do not comprise much of the overall market (6), the energy sector helped spark many new jobs, especially in the fracking centric states such as North Dakota, Texas and Colorado. (7) Pain from the oil patch went well beyond our borders causing acute problems in petroleum exporting countries such as Russia, Saudi Arabia, Iran, Norway and even Canada.
Economic activity in China might exceed most other countries, but the actual rate of growth in 2015 was the lowest in 25 years. (8) China qualifies as the second largest economy in the world and has been a prodigious consumer of raw materials. Moody’s recently warned China of a pending downgrade to their credit rating due to rising debt and diminishing exchange reserves. (9)
After going four years without a market correction, we have now experienced two in the last 6 months. And after all, you can’t really defy gravity, right?
The Wright Brothers came to a different conclusion. They applied concepts originated by Bernoulli and Newton (an object in motion stays in motion) that eventually led to their successful defiance of gravity in 1903 at Kitty Hawk.
Does the stock market
The chart below depicts the S & P 500 since January 1, 1950. We want to draw your attention to the top right of the graph – the stock market ended the quarter near its highest level ever. Leading indicators, oil, China, the 12% slide….all gone.
The Fed’s fight against gravity is best understood through the lens of historical context. The 1937-38 recession, particularly painful on the heels of the Great Depression, drew enormous academic attention, mostly concluding that the Fed should have maintained a more aggressive monetary policy for a longer period of time. As either students or professors, Christina Romer (Chair of Council of Economic Advisers), Ben Bernanke and Janet Yellen all wrote such papers. Their sensitivity to a potential repeat of that recession helps to explain the tendency toward aggressive monetary policies being deployed today.
On December 16, 2015 the Fed raised interest rates in a well-telegraphed baby step toward normalization. They also announced plans for four additional rate increases in 2016. The stock markets’ bout of indigestion ensued almost immediately afterward, and, coincidentally, Japan, Europe and China moved toward more aggressive monetary policies. Almost all foreign currencies continued to fall against the U.S. Dollar. Who would leave their money in German Bunds with negative interest rates when they could move money to the U.S. and earn a positive, albeit modest, return?
From the time of that December rate hike, the probability of another increase in rates for April has dropped from 90% to below 5%. (10)
The high value of the U.S. dollar, as articulated in earlier notes, pressures both sales and profits of companies selling outside of the U.S. Almost all of the companies we follow have identified currency exchange as a quantifiable drag in the past several quarters. Fewer interest rate hikes, given everything else equal, should allow the dollar to move down and the graph below (11) suggests this is already occurring.
Lower interest rates will support more corporate debt to facilitate acquisitions, buybacks and further lower expenses.
The Fed has proven their prowess in helping the market to defy gravity. However, with current earnings projected at $124, the market (2,309 as of 4/5/16) trades at almost 18 times, up from the 14 level back in February. Though we do not foresee a significant change in the earnings multiple, given our expectations for direction in the factors that comprise it, there is an equal probability for the multiple to subside rather than expand. Bottom line: we expect stocks to be range-bound and volatile until the fog clears on both the economy and this unique election cycle.
The graph depicting the market performance dating back to 1950 should serve as a reminder about the perils of market timing. Lacking either a long term focus or discipline, an investor could have responded to January and February like a hand on the hot stove – by jumping out of the kitchen. That’s not our approach. Instead, we put greater faith in our own research than the market’s feelings and, in March, the rebound unfolded. You have tasked us with keeping you safely on course and to fulfill that responsibility, we have learned how to use the principles of both gravity and relativity to navigate pockets of turbulence.
1. All references to “the market” in this note shall refer to the S & P 500.
2. The technical definition of a “correction” is a downward price movement of at least 10%
3. Federal Reserve Bank of St. Louis
4. Federal Reserve Bank of St. Louis. The higher the graph, the greater the spread over Treasury costs.
5. Wall St. Journal; March 16, 2016
6. Energy was 6.84% of the S & P 500 at the end of March; Standard & Poor’s.
8. Wall St. Journal; January 19, 2016
9. Financial Times; April 1, 2016