Shaken, not stirred - January 2019
Snow globes have an uncertain origin, but were on display at the International Expo in Paris of 1878. (1) Below, one can see a clear depiction of a wintery scene: house with a fireplace, three trees and a snowman. Once shaken, the small snowflakes fill the globe and blur the view. Critically, the perceptions generated from shaking prove ephemeral and, once the snow settles, the original image is restored.
The New York Stock Exchange, celebrating its 61st birthday when the snow globe debuted, reminded everyone during the 4th quarter that it too is all about perspective. (2) Howard S. Marks, the highly respected manager of distressed debt, and author recently wrote:
“You just can’t think of the market as this machine. There is no schematic for how it works. It just picks funny things to obsess about on the positive side for a while and then the negative side.” (3)
It’s almost as if the stock market exists inside a snow globe that periodically gets shaken. This note will examine the genesis of the recent storm and to provide historical context.
In October 2007, the stock market began a 517 day descent (peak to trough) not experienced in a generation. Iconic ghostly images remain of Lehman Brothers and Washington Mutual, victims of excessive debt, a burst real estate bubble and the great Wall Street rip-off known as Collateralized Mortgage Obligations. Economic contraction led to near 10% levels of unemployment. Pessimism prevailed...
Until, as Marks implies, the market focused on the positives. On March 9, 2009, after plummeting 56.8%, the S & P 500 finally hit bottom. Equities traded at low multiples not seen in decades and provided a dividend yield (3.2%) higher than 10-Year Treasury Bonds (2.16%). Europe was a mess and China too young to attract capital. In a global “flight to quality”, capital poured into the U.S. There was zero inflation. Monetary policy in every developed country was aggressively easy. Stocks were cheap and had no real competition. The snow globe shook, and the buying began.
Most observers, afforded the glossy view from hindsight, would agree that the U.S. stock market moved mostly straight up since bottoming in March of 2009. There were, however, opportunities along the way to get scared and jump out. On three separate occasions the stock market dropped by more than 10% including:
- 2010; The S & P 500 fretted over European debt and experienced the Flash Crash on May 6th, a harrowing 1,000-point drop blamed on a technology glitch. In 70 days, the market dropped 16%.
- 2011; Inability to reach a budget agreement led to U.S. government shutdown and eventual downgrading of U.S. debt. The S & P 500 lost 19.4%. The decline lasted 157 days.
- 2016; the market lost 12.4% over 65 days, instigated by fears of Brexit.
Avoiding emotions during these few challenging periods proved highly rewarding.
4th Quarter 2018 Snowstorm
The S & P 500 dropped nearly 20% between October 1st and Christmas Eve. Only twice in the past three decades has the market dropped by more than 20%, so this was meaningful.
The trigger? Last quarter, and again in our Special Report (12/24/2018), we suggested that the valuation of the market portended either a period of subpar returns or a correction in prices.
The high valuation’s implied optimism left the market vulnerable to any disappointing news, and the challenges kept mounting.
Nothing spooks the markets as much as a recession. Since 1970 the U.S. has only experienced five serious bear markets including: 1972-1974 (oil embargo and recession), 1981-1982 (recession), 1987 (20% in a single day), 2000 (dot com bust) and 2008 (The Great Recession). Except for 1987, each presaged a recession. This makes sense because the stock market functions as one of the Leading Economic Indicators, a data point used by the Conference Board to determine our official position in the economic cycle. What are the rest of those indicators telling us today? The two charts below both provide cause for concern.
- Housing inventories are rising, pointing to a slow down. (4)
- The spread between 2 and 10-year Treasuries is hovering near zero. Even as the Fed tightens, investors are buying longer term bonds, typically in anticipation of a slower economy. (5)
And, it’s not just the U.S. The Manufacturing Purchasing Manager’s Index (PMI) in China dipped below 50, the first contraction in factory activity in China in 19 months. (6) Similarly, the PMI in Germany experienced its sharpest decline in four years, with business leaders pointing to both U.S. trade policies and Brexit for the erosion in confidence. (7)
Recessions, a natural negative consequence associated with capitalism, represent the biggest threat to the stock market and the least manageable.
Equity markets tolerated nine interest rate hikes in the past three years. However, the hawkish tone assumed at the Fed’s December meeting, with cracks already appearing in the economy, was more than the market could endure.
The drying up of liquidity can be seen in the financial markets’ growing aversion to risk. Specifically, the spread between lower quality bonds and Treasuries has been steadily rising since June. (8)
In September, the financial publication Barron’s rhetorically asked: “Have the financial markets lost their fear of being Tariffed?” (9) The author suggests that the markets interpreted tariffs mostly as rhetoric, designed to establish negotiating leverage. This Pollyannaish view seemed to be playing out when stocks rallied the last week in November, with a weekend meeting between Trump and Xi expected to end the tensions. In fact, the S & P 500 remained moderately in positive territory for the year at the end of November. (10) When nothing positive materialized that weekend, the markets view of tariffs became more grim and stocks moved powerfully down for the next three weeks.
Finally, the reality of Brexit, which initially scared the equity markets back in 2016, set in. In a backdrop of economic concerns, both tariffs and Brexit serve to undermine global trade, supply chains and business confidence.
The net result of these four problems has been the worst December since the Depression, the worst fourth quarter since 2008 and “the worst year on record in terms of breadth of negative asset returns in dollar terms, with data going back to 1901.” (11) Translation: no place to hide with large stocks, small stocks and foreign stocks all down and bonds treading water.
The economy has a natural cycle and typically requires time to self-correct. Though the biggest risk, a recession is not a foregone conclusion.
Consumers (still the biggest driver of economic growth) remain confident. The December reading from the University of Michigan Survey of Consumers read 98.3, up from 97.5 in November and continues the upward trend that started in 2008. (12) Early indications suggest that Christmas sales were the strongest in six years. (13) Also, the Institute for Supply Management Manufacturing Production Index was at 60.6 in November, down modestly from the October reading, but well ahead of the 50% mark generally associated with a growing economy. (14) (Note that the Employment data that was released this morning, Friday January 4th, has provided considerable relief to the equity markets, indicating that the economy appears to remain strong).
The “artificial” challenges, including tighter monetary policy, trade tariffs and Brexit were all set in motion by individuals and each can be altered or reversed.
It was tough talk from Fed Chairman Powell on December 18th that exacerbated market volatility. However, on December 22nd, NY Fed President John Williams backed off the hard line by saying, “The Fed is ready to reassess and reevaluate its forecasts if there are risks to that outlook that maybe the economy will slow further.” (15) Subtle changes in Fed comments are capable of assuaging apprehensive markets. (Note: This was written in advance of the January 4th dovish comments by Fed Chairman Powell that, when combined with the favorable jobs report, lifted the market by more than 3%.)
Similarly, Donald Trump acknowledged the negative impact from tariffs by tweeting, on the last trading day of the year, “Big progress was being made.” (16) Apple’s revenue warning on the evening of January 2nd removed any doubt about the damage being inflicted from tariffs.
Brexit, its implications for global trade and a united Europe, is admittedly complex. However, it is politically solvable.
The Original Image
Remember our basic thesis that the snowflakes impact perception, but the house and the trees captured in the globe never really change. The same can be said of the stock market:
- It offers a higher rate of return to long term investors than the risk-free yields from Treasury Bills, but only in exchange for the acceptance of substantial volatility in those returns from year to year.
- The uncertainty of those returns makes stocks best suited for long term investors.
- Because of the innate risk, tolerance should be carefully gauged. As uncomfortable as the fourth quarter was, the calendar year 2018 returns were well within “normal” bands. Please do not be shy if you have recently experienced more angst than you care to endure. Financial options are available. Just ask us.
- The stock market needs to be “handled with care” and “managed” through a reasonable and rational strategy, employed with discipline.
- Generally, the worse the market performs, the better the future expected returns. The valuation of the stock market has moved from high to average. However, interest rates, which have sunk on economic concerns, remain well below historical norms and present less competition for stocks.
Market performance should be seen through the prism of goal achievement. As we mentioned in our Special Report (12/24/18), most portfolios lost money this year, but inflation expectations have subsided and return assumptions have risen. It’s human to “feel” the losses while not necessarily incorporating those mitigating influences. What is the net impact of all these changes?
- In the initial scenario above, an investor with $1 million at the beginning of the year might expect to earn a hypothetical 4.5% per year. Such an investor could withdraw $51,850 per year for 25 years, with each yearly withdrawal adjusted for an expected inflation rate of 2.15% per year.
- In column two the investor starts with a 5% loss in their portfolio, but inflation drops from 2.15% per year to 1.73% per year (just as actual inflation expectations have dropped between the beginning of 2018 and the beginning of 2019). In order to sustain the draw, the first distribution must drop, but only by $400 per year, or around $35 per month.
- In the third column the expected rate of return rises, but only by .10% per year. The net result of the 5% loss in portfolio value, the reduction in inflation and the modest uptick in return assumptions is that the portfolio can support a slightly higher draw rate than before the three changes.
The stock market does act like it exists inside a snow globe and the shaken flakes can change perceptions. We have no control over that. Is it possible that The Little River Band pondered this issue when they asked, “What’s it like inside the bubble? Are you always in confusion? Surrounded by illusion?”
Hard to say, but we do agree with their retort, “Hang on, help is on its way.” (17)
Happy and Healthy New Year.